Why would increased saving reduce GDP? Saving, correctly understood or defined, is the acquisition of interest- or dividend-earning financial assets, such as bank deposits, certificates of deposit, mutual fund shares, bonds, and stocks. Thus saving is not cash hoarding but the transfer of funds from income earners to borrowers who spend the funds. Savings are the source of loanable capital sought by businesses, as Adam Smith in the Wealth of Nations well explains: “By what a frugal man saves, he not only affords maintenance to an additional number of productive hands, but like the founder of a public workhouse, he establishes as it were a perpetual fund for the maintenance of an equal number in times to come.” Also, “Capitals are increased by parsimony. . . . Whatever a person saves from his revenue he adds to his capital, and either employs it himself in maintaining an additional number of productive hands or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits.” Indeed, increased savings make increased borrowing at lower interest rates possible.

In his concluding paragraph, Gibson also quotes an explanation from Ludwig von Mises that is in accord with Smith’s argument and in contradiction to his earlier income-lowering claim: “There is but one means to improve the material well-being of men, viz., to accelerate the increase in capital accumulation as against population.” Gibson goes on to state: “Capital accumulation requires saving, saving requires confidence. . . .” I think he needs to acknowledge the error of attributing an income-lowering effect to savings or else explain the contradiction in the two paragraphs. We cannot get rid of the Keynesian nonsense that increased saving causes poverty—the so-called paradox-of-thrift proposition—by continuing to employ Keynes’s misconceived definition of saving to mean cash hoarding.

Warren Gibson replies:

Professor Ahiakpor quite reasonably questions my assertion that an increase in saving could temporarily suppress GDP. I lacked the space (and inclination) to explain this assertion in the article, but here it is: I agree with him that savings are invested in real assets, and I am willing to stipulate no growth in cash balances. And of course new investments do add to GDP. So it looks like a wash: some consumption is simply shifted to capital goods. But I suggest that if we consider the time structure of production we see a difference. Capital goods are priced at the estimated discounted value of the final products they are intended to produce, and because of this discounting the present value of new investments could well be lower than the consumption goods they replace. Only in the fullness of time will the productivity of the new capital work its way down to consumption, at which time we would expect increased GDP, other things being equal.

So why don’t they apply the same logic to the economy as a whole? The only tenable answer is that they are under the spell of the economic miseducation inflicted on the minds of economists and many among the general population by John Maynard Keynes. They believe that consumer spending drives the economy, without having stopped to consider from where consumers get the means to spend.

Consumption Doesn’t Need Stimulation

On their own—that is, in the absence of government handouts in the form of welfare payments or unemployment compensation (funded by taxpayer money)—people acquire the means to spend by earning income from producing and selling goods and services or directly selling their labor services. If they borrowed the money to spend, it must be from someone else who has earned income from production. And as Adam Smith long ago noted in The Wealth of Nations, “[C]onsumption is the sole end and purpose of all production. . . . The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it.”

Why else does anyone work other than to acquire the means to purchase goods and services? That is why consumption spending does not need stimulating. What we currently save out of our incomes is to enable us to smooth out our consumption spending over time or to acquire the means to increase consumption and/or our income-earning capacity in the future.

Such household investments may take the form of bank accounts or bonds to earn interest income, stocks to earn dividends, or educational skills to earn higher future wages and salaries. The only part of our unconsumed income that we do not devote to increasing our future capacity for increased consumption spending is cash hoarding; cash does not earn interest or dividends. But in normal times, when we are not too scared to keep our savings in bank accounts or to purchase stocks or bonds, cash hoarding constitutes a very minor part of our unconsumed income. Meanwhile, what we save is spent by borrowers of our savings, mostly producers of goods and services.

On the basis of these fundamental truths about how people manage their financial affairs and drawing on the wisdom of Adam Smith, Jean-Baptiste Say constructed the thesis now named after him, Say’s Law of Markets, in his 1803 Treatise on Political Economy. It is from production that people earn incomes to purchase those goods and services they themselves don’t produce:

Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have [acquired] this money itself by the sale of productions of our own. . . . It is then in strict reality with their productions that [people] make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands.

The law simply says that “productions can only be purchased by productions” (Say, Letters to Malthus, 1821).

Regarding the need for savings rather than consumption spending to promote economic growth, Say noted that:

The public interest is . . . not served by consumption, but it is served and served prodigiously by saving, and though it seems extraordinary to many persons, not being any the less true as a consequence, the labouring class is served by it more than anyone else. These persons think, perhaps, that the values which the wealthy save out of outlays on their personal pleasures in order to add to their capitals are not consumed [spent]. They are consumed; they furnish markets for many producers; but they are consumed reproductively and furnish markets for the useful goods that are capable of engendering still others, instead of being evaporated in frivolous consumption.

Failing to understand all this, Keynes made a fetish of consumption spending as the engine that drives an economy during the 1930s, especially in his famous book The General Theory of Employment, Interest, and Money (1936). He argued that Say’s Law applies only to an economy in which there is no unemployment or one in which money is not used as a means of exchange. Neither claim is true. However, many an economist has been hooked on Keynes’s miseducation ever since. In macro models legislated unemployment compensation is listed among “automatic stabilizers.” The thinking is that paying the unemployed so they would keep spending will sustain the economy’s so-called aggregate demand. Even if proponents of that view recognized that the government would have to pay the unemployed from its tax revenue (or borrowed funds), they still do not realize that total spending would not change. But unless the government borrowed the additional funds from outside the domestic economy, what it takes from purchasers of its bonds will not be available for private borrowers to spend on investment projects or for their own consumption. Put differently, variations in the level of government spending, besides the portion funded by external borrowing, do not change total spending in the domestic economy.

The Need for New Production

As for stimulating economic activity, it is not the level of consumer spending but new directions in production that make the difference. Entrepreneurs conceiving of new ways to meet economic necessities or desires in the marketplace create new incomes with their positive ripple effects in the economy. Meeting such needs requires that entrepreneurs find the savings, or loanable funds, to acquire the resources to engage in production. Of course, followers of Keynes’s mistaken 1937 view—“The investment market can become congested through the shortage of cash. It can never become congested through the shortage of saving. This is the most fundamental of my conclusions within this field”—do not recognize the necessity of savings to fund investment expenditures. But the fact is that the government’s taxing the employed or borrowing the community’s savings to pay people who are unemployed does not help entrepreneurs in their socially useful task of new wealth creation. This is also how we should recognize the failure of the $787 billion so-called stimulus of February 2009, the subsequent Cash for Clunkers program, and the first-time home purchasers’ subsidies of 2010 to stimulate economic recovery. The money to fund such programs has to be taken from the economy: There is no injection of new money by the government; it effects only a transfer.

Specialization and Trade

Adam Smith in The Wealth of Nations made the salient point: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” The prudence is in the fact that households typically do not aim to be their own tailors, shoemakers, wine makers, homebuilders, or producers of all the numerous things they need, but rather specialize in those things they can produce at the cheapest cost and buy the others in the marketplace—the advantage of specialization and trade. That’s how Smith came to urge nations to adopt the wisdom of households in the management of their production and consumption activities and to reject mercantilist restrictions on trade and opt for free trade instead.

We can apply the same wisdom of households to the question of paying the unemployed. Just as no household would expect that giving money to any of its members to spend would stimulate wealth creation for the household, so it is for the economy as a whole. An economy is little more than the collective activities of households. It is ultimately the aggregation of household production and consumption expenditures that is called gross domestic product, GDP.

We also can learn from the experience of Europe. Its greater “generosity” in unemployment compensation does not produce less unemployment and greater economic growth but higher levels of unemployment and relatively poorer economic growth than in the United States. Extending the period of unemployment insurance compensation only assures that the unemployment rate stays permanently higher than the 4 to 7 percent range within which it fluctuated over the last 20 years or so until 2009. Arguing about the ballooning deficit may help stop the extensions, but that really is a side issue. The real point is that paying people who are unemployed simply discourages them from seeking and/or accepting alternative job offers quickly. And such payments do not change total spending in the economy.

It is truly a pity that followers of Keynes’s mistaken understanding of how a monetary economy works now claim the relevance of his ideas to our current economic situation and are implementing some of his misconceived policies.

That the Obama administration based its policy on the assumption that every dollar of government expenditure has $1.50 worth of impact is a remarkable testimony to Keynes’s observation in that book: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

So it is that Keynes’s false expenditure-multiplier argument, severely criticized by his contemporaries, can now be invoked in support of massive spending.

The argument is founded on two key assumptions that turn out to be false. First is the notion that savings are not spent but rather are withdrawn from the expenditure stream. That assumption prompts stimulus proponents to believe that taxation or government borrowing expands total spending, while leaving the money in the private sector retards it. The flaw is the equation of saving with hoarding. People save their unconsumed income in bank deposits and mutual funds, purchase bonds (private or government) and stocks, or some combination of all of these. Thus savings are the sources of funds spent by borrowers. And as the classical economist most admired by Keynes declared: “No political economist of the present can by saving mean mere hoarding.”

That was Malthus, who was reaffirming Adam Smith’s explanation in The Wealth of Nations that “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people.” Note that “to consume” does not only mean “to eat.” It also means to “use up.” Thus John Stuart Mill elaborates Smith’s explanation: “The word saving does not imply that what is saved is not consumed, nor even necessarily that its consumption is deferred; but only that, if consumed immediately, it is not consumed by the person who saves it. If merely laid by for future use, it is said to be hoarded; and while hoarded, is not consumed at all.” And when savings are borrowed by businesspeople, they are “all consumed; though not by the capitalist. Part is exchanged for tools or machinery, which are worn out by use; part for seed or materials, which are destroyed as such by being sown or wrought up, and destroyed altogether by the consumption of the ultimate product. The remainder is paid in wages to productive laborers, who consume it for their daily wants; or if they in their turn save any part, this also is not, generally speaking, hoarded, but (through savings banks, benefit clubs, or some channel) re-employed as capital, and consumed.”

Keynes’s lack of formal training in economics, besides his eight weeks of tutorials from Alfred Marshall, may explain his failure to interpret correctly Marshall’s own restatement of the meaning of saving, which Keynes himself quoted: A man “is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labor and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”

The Government Spending Shuffle

The multiplier’s second incorrect premise is that government expenditures are “autonomous”; that is, government spending does not depend on current income. It may be true that politicians pay hardly any attention to the level of income in the economy when they choose how much government should spend. That it planned to spend $787 billion when the economy was in a recession is ample testimony to such an inclination. But the amount the government spends comes primarily from taxes paid out of the public’s current income. Furthermore, government expenditures above tax receipts have to be paid for through the sale of bonds, purchased out of the public’s savings. Thus increased government spending simply shuffles around currently earned incomes and savings without adding anything to total spending. And when government shifts more of current income toward its favored expenditures, the economy’s future functioning is impaired because such spending yields less than would have resulted had the income earners spent the money themselves.

Borrowing from the rest of the world may add to total spending in the United States at the expense of spending in some other countries. But it is hard to conceive of foreign savers eager to send their unspent incomes to the United States when their own economies are experiencing recessions. Besides, the Keynesian multiplier idea is supposed to hold in every country. Thus it is unrealistic to expect that all governments would be able to increase their borrowing from “the rest of the world” in order to increase total world spending.

Borrowing from a central bank (inflation) may increase total spending beyond currently generated incomes. However, the stimulative effect can only be temporary, until nominal wages adjust to the resulting rise of prices and participants in the capital markets have taken measures to hedge against future capital losses. This is the classical forced-saving doctrine that Keynes read but failed to interpret correctly, thinking it applies only to an economy operating at full employment.

Indeed, David Ricardo described as an “absurdity” the belief in the ability of a central bank to promote lasting economic prosperity by issuing paper money. The belief, he said, attributes “a power to the circulating medium which it can never possess.” Keynes encountered a similar warning about the futility of a central bank’s money creation to promote prosperity in Ricardo’s Principles but unwisely dismissed it as having relied on the assumption of full employment. The Federal Reserve evidently has been attempting to prove Ricardo wrong with its reckless money creation, especially since the third quarter of 2008. It has lost so far.

Production Drives Economies

A fundamental flaw of the Keynesian multiplier argument, besides the two faulty premises, is its failure to recognize that consumption spending follows production and the earning of income. It is incorrect to think of spending as one consumer handing over a fraction of her income to another to spend. Rather, individuals engage in production from which they earn incomes by selling what they do not consume. From the incomes thus earned, individuals purchase goods and services they themselves do not produce. The remaining income may be held in cash (hoarding) or turned over to others through purchasing interest- or dividend-earning assets (saving). That is why the classical economists emphasized that production, rather than consumption, drives an economy, another explanation Keynes encountered from Mill but could not interpret correctly:

What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because everybody would have twice as much to offer in exchange.

Before Keynes borrowed Richard Kahn’s formulation of the expenditure multiplier, founded on consumption expenditures, other analysts had argued the “multiplying effect” of production, as Mill explains above. The argument is that increased productivity or a surge in production within one sector of an economy stimulates increased production in others as a result of the additional demand or income generated by that sector. Thus the discovery of high-yielding varieties in agriculture or the introduction of more advanced information-processing technologies into computers may have multiplying effects on production in other sectors of an economy. That explanation is a far cry from the Keynesian belief that by taking some of the public’s income to subsidize the arts, pay the unemployed over an extended period, or cover children’s health care, government will stimulate increased production in the rest of the economy. Even necessary expenditures on infrastructure entail forgone production. For a correct analysis, one always has to keep in mind the displacement effect of government spending.

Among Keynes’s contemporaries who criticized his multiplier argument most consistently was R. G. Hawtrey, who declared it variously as “practically untenable, . . . nonsense, . . . [and] fallacious,” and said that it does not represent “a correct account of the sequence of events.” (See more of such criticisms in my “On the Mythology of the Keynesian Multiplier,” American Journal of Economics and Sociology, October 2001.) Evidently, those who recommend massive government spending have paid little heed to previous criticisms of the multiplier argument. They presumably were impressed by its expression in algebra and geometry in modern macroeconomics textbooks. They also have not learned from the failure of former President Bush’s tax cuts of 2008, which were meant to stimulate consumer spending and spare the economy from a downturn. Cutting taxes, only to borrow from the public to fund the increased deficit, could not have increased production. Perhaps the failure of the so-called stimulus to bring economic recovery will finally teach the right lesson on the impotence of increased government spending.

Economic recessions typically are the result of a mismatching of production with consumer demand. Given the incentives of producers to correct their own mistakes to recover profitability, economies sooner or later recover from recessions on their own. But recovery can be forestalled when governments undertake expenditure or regulatory measures that frustrate the corrective actions of private producers and consumers. Massive, diversionary spending by government does not help the recovery process.

Many Americans are old enough to remember things that happened prior to the passage of the Social Security Act in 1935, but where is one of them who ever watched a human being starve? No, we wouldn’t “let them starve.” So why is it so widely believed that, without Social Security benefit payments, many people would go hungry?

The social security idea is based on the questionable premise that a person’s usefulness ends at age 65. He is supposed to be without savings and without capacity to continue to earn his living. If that premise were correct, it would be easy to see how hunger might develop among the aged. If they’re really good for nothing, who wants to be bothered to look after old folks!

Lumping people into groups and jumping to conclusions about each group (that is, people over 65 would go hungry without Social Security) is a standard procedure of government planning. A corollary conclusion is that breadwinners under 65 must be compelled by force of law to respect and care for their elders. These conclusions rest on false assumptions made by those having no faith in anyone else as an individual. Their faith is in coercion, and they thus conclude that government holds the answer to every problem.

Reduces Incentives

To those of little faith, it is necessary to explain again and again and again that government is non-creative and can distribute only what it first taxes away from the productive productive efforts of individuals. “The people” are—first, last, and always—individuals, some more economically creative than others, but each worthy of respect as a human being. To tax a man’s earnings and savings, for other than defensive purposes, is to reduce his capacity and his incentive to care for himself and for others, rendering him part slave to others and thus less than human. On the flip side, he who either volunteers or is forced to look to the taxing power of government for his livelihood is also enslaved and debased.

Slavery has been tried in the United States, unfortunately, and a major reason for its failure is that it was, and is, an unproductive way of life; it lets people go hungry. It is also morally degrading to master and slave alike. Yet, we are being told that without compulsory Social Security taxes upon the young and strong, the oldsters among us would go hungry—perhaps starve; we are invited to try once again a semi-slave system—under benevolent masters, of course. Well, those socialists are dead wrong. Their premises are faulty. Free human beings may be counted upon to care well for themselves and for their fellow men, voluntarily.

What should concern us all is that, if we persist under the false premises of the Social Security idea (socialism), many Americans will go hungry—not only physically hungry, but morally and spiritually starved as well.

The prime argument against Social Security is in the moral realm. Giving to one individual or group the fruits of the labor of others taken from them by coercion is an immoral procedure, with destructive effect upon the sense of personal responsibility of everyone involved. . . .

True to form, promoters of Keynesian economic theories are encouraging governments to engage in active policies to manage demand and consumption. Their selective memory contains a gap that overlooks the stagflation of the 1970s, soaring public-sector deficits of the 1980s and 1990s, and relentless growth in government control over private lives during most of the post-World War II period.

It would be wise for the rest of us to resist their belief that governments can fine-tune an economy by making adjustments in taxes or government spending or manipulating interest rates. This caution is offered since there is a dearth of evidence to support their views. As it is, Keynesian policies are based on a widely accepted fallacy that economic growth is driven by demand, especially consumption spending. Perhaps unwittingly, those who support this view see savings as a nonessential and even counterproductive activity that undermines the health of the economy.

Nothing could be further from the truth, since economic growth requires the fuel provided by savings. When households decide to boost their savings, the pool of investment capital is increased. In turn, interest rates are pushed down naturally and a larger number of investment projects can be undertaken.

The negative view of savings is painfully familiar in Japan. However, attempts at demand management by Japan’s government over the past decade have failed. Now that interest rates are virtually at zero and fiscal spending has become constrained by high debt levels, Tokyo has exhausted conventional policy tools to offset its economic malaise. The truth is that these traditional tools do not work.

Instead of the Keynesian presumption that demand drives economic growth, the reverse is true. Demand is the result of economic growth. Paraphrasing an economic law named after the nineteenth-century French economist J. B. Say, market economies work on the basis of the supply of one good creating the demand for one or more other goods. In other words, you must first produce to be able to consume.

Reviving the neglected verities of Say’s Law requires debunking a belief system that is subconscious and seldom subjected to introspection. One problem in exorcising Keynesian policy influences is that the demystification requires understanding some basic economic theory that is hard to grasp. Further, many implicit assumptions behind much of Keynesian analysis will seem obscure in their effect or validity to lay persons.

Understanding Say’s Law begins with the commonsense observations that purchasing power as the basis for consumption necessarily arises out of the act of production. Moreover, just as goods cannot be purchased unless people earn income from producing, so goods cannot be consumed if they are not produced. Hence, the driving force of a market economy is supply and not demand.

This logic shows that economic growth depends on how much is saved (and how well it is invested) instead of how much is consumed. Savings and investment can lead to increases in the per capita quota of invested capital so that increases in productivity lead to higher real wages and increased prosperity. Spending on consumption leaves fewer resources for production.

Policies to force interest rates artificially lower to boost consumption are actually counterproductive since they discourage savings. Such policies also have the undesirable effect of encouraging long-term investment although consumers have not changed their preference for future goods over present goods.

The Grasshopper and the Ant

If all goods were consumed and none were set aside to invest in time-consuming production, we would be in the situation faced in the fable of the grasshopper and the ant. While the ant toiled away, the grasshopper derided him for not playing in the sun. When winter came, the grasshopper faced starvation for not laboring in the present to prepare for the future. Keynes, being childless, perhaps saw no merit in the wisdom of nursery tales.

Attempting to increase aggregate demand by increasing government spending also will not restore growth. There is little evidence to suggest that fiscal or monetary policies have a systematic effect on real economic variables.

In fact, government’s printing money and spending more cannot induce stable long-term growth because those activities do not generate new wealth, capital, or savings.

Sustainable economic growth requires an expansion of the capital base, and that requires savings. When central banks push down interest rates to put more money into the economy or when governments run deficits, funds are diverted from wealth generators to wealth consumers. A better move would be to cut government spending so that resources are released for productive use.

It is astonishing that the failed principles of central planning are readily applied in government attempts to manipulate market economies. Nevertheless, policymakers are as incapable of acquiring the knowledge needed to control markets as planners are. Even though macroeconomic meddling to “correct” market conditions involves the same presumptions that (mis)guided central planners, supporters of Keynesian policy willfully ignore evidence from the failures of communism and socialism.

Although market economies experience fluctuations, extreme booms and busts are caused by the sort of meddling that is supported by Keynesian prescriptions. These interventions also interfere with the innate self-adjustment mechanisms that would generate stability in capitalist economies.

Alas, Keynes’s teachings remain very much alive and just as wrong now as they always have been. Apparently the discovery that centralized economic decision-making through political mechanisms is inferior to decentralized market mechanisms has already been lost on some.

It’s a constant refrain among politicians and the news media: America has a low savings rate. This, it is said, has dire consequences for the long-term health of the economy. Some analysts put the personal savings rate—the percentage of disposable income that isn’t consumed in a given year—as low as 2.1 percent in 1997, a 63-year low. Although this undercounts the real amount of American savings and investment, there is no doubt that the private savings rate is near an all-time low.

Why is this? Are Americans simply irresponsible? Should government force households to save more money for a rainy day, as some doomsayers have suggested?

On the contrary. America’s savings crisis is almost totally manufactured by government itself. Through punitive taxation and the growth of the welfare state, big government has legislated against the habits of thrift and delayed gratification on which human progress is based. The decline in the savings rate over the course of the twentieth century isn’t just a minor economic trend. It represents the threat that government expansion poses to the principles on which successful human civilization rests.

What Is Savings?

It’s worth pausing to consider the definition and origin of savings. After all, economists aren’t talking simply about a bank account, or even an investment in stocks or bonds, when they address the issue of savings. For example, one’s home is a form of savings, in that the value of the home usually appreciates even as one uses the home for current consumption (shelter).

Indeed, the official savings rates don’t factor in the appreciating value of assets. They reflect the difference between reported income and reported expenditures. The Commerce Department, which generated the 2.1 percent rate cited above, doesn’t actually track inflows and outflows of wealth. It doesn’t include the rise in the value of investments in individual retirement accounts, 401(k) plans, real estate appreciation, or the rise in value of mutual funds or corporate stock. It doesn’t count the implicit wealth people accumulate in pension plans. The Federal Reserve computes an alternative measure incorporating some of these factors and estimated that the 1997 savings rate was actually 7.1 percent of disposable income. Still, that’s pretty small compared with the savings rates of other countries. In Asia, rates reach as high as 20 percent.

The reason the issue of savings is so important is that deferring consumption—which is probably the best definition of savings—is essential to human happiness. That statement may seem paradoxical. How can forgoing current pleasure or satisfaction by choosing not to buy a good or service today increase one’s happiness? To answer that question, it’s important to look at how four closely related economic behaviors—savings, insurance, investment, and specialization—arose among prehistoric human cultures.

A Short Economic Prehistory

The earliest societies historians can identify are the nomadic hunter-gatherers who inhabited various regions of Africa, Asia, Europe, and the Americas. Throughout most of their history, these hunter-gatherers traveled in small groups of 20 to 30 related individuals—a patriarch and matriarch, their children and grandchildren, mates from neighboring groups, and other assorted relatives. They worked together both to hunt animals for meat and to gather fruits, vegetables, nuts, simple tools, and other useful objects. Because these groups were constantly on the move, their housing consisted of either portable shelters (tents, or yurts) or structures they found or could construct quickly (caves, lean-tos).

In this earliest of human societies, the line separating political, economic, and spiritual institutions was blurred or nonexistent. Few of the tools future civilizations would use to draw such lines were available to the hunter-gatherers. Their nomadic lifestyle, for example, provided little opportunity to develop or enforce private property rights, not only over land but over the products that land might produce. Private property rights are indispensable if societies are to separate the public from the private, the sphere of human activity over which political power is freely wielded and the sphere over which it is limited or excluded.

Furthermore, the small size of these societies necessarily reduced the extent to which differences in knowledge or talent resulted in the development of markets or a division of labor beyond the most rudimentary one. Finally, because they lacked any practical means of saving and transporting food of more than limited quantities, these earliest human societies provided little reward or incentive for hard work. All that was hunted or gathered was consumed relatively quickly. An individual who was exceptionally talented as a hunter or gatherer had no reason to invest much of his time performing those tasks.

Stages of Economic Discovery

Even under these conditions, however, developments occurred in economic exchange and institutions. The earliest hunting and gathering humans cooperated with each other to derive sustenance from a sometimes-forbidding environment. They had to develop terms of trade and rules of work and reward in order to put members of the clan or band to productive use. A simple division of labor did evolve, based on age, sex, and physical prowess (or infirmity). We know that these small societies, while primitive and sometimes brutal, also gave opportunities for those with different natural talents and skills. And while the invention of money was far in the future, these early humans engaged in mutually beneficial trade in valuable goods that sometimes spanned surprising distances.

Archaeologists and anthropologists divide human prehistory before metallurgy into three periods: Paleolithic (Old Stone Age), Mesolithic (Middle Stone Age), and Neolithic (New Stone Age). The names suggest a categorization based on stone technology, but the real dividing lines among these periods involve changes in geography and corresponding changes in economic technology and organization.

For the purposes of understanding economic history, the Paleolithic Period is critical. It lasted from 2.5 million years ago until about 10,000 B.C. Humans during this period include Homo erectus and archaic Homo sapiens. Early in the period, humans used simple tools made either of the core of a stone after pieces had been flaked off, or the flakes themselves. They used fire (discovered sometime between 1 million and 500,000 years ago) to drive or prod animals, to prepare food, and of course to keep warm.

Later, in the so-called Middle Paleolithic Period, flake tools were developed into a wide array of scrapers, borers, and points used to manipulate animal kills and other materials. This was the period of Neanderthal Homo sapiens in Europe and some humans even closer in appearance to modern humans. Their tools may have improved their hunting but, more important, there is evidence of extensive social cooperation not only in hunting but in storing and exchanging food. As one writer has noted, hunting is not just about killing animals. Killing animals is the easy part, whether it is by using weapons, by trapping, or by driving prey over cliffs. The difficult part lies in the organization of personnel so that they are in the right place at the right time and with the right gear to ensure a better-than-average chance of success.

Even more difficult is the task of coping with failure, weather, and the decline of animal stocks. Remember that these societies lacked effective technologies for storing food, and a diet of nuts, berries, and other gathered foods was of insufficient quantity or nutritional value to tide families and clans over in the event of a seasonal decline of game.

Humans Beings Invent Savings

It is here, in the Middle Paleolithic populated by humans whose language skills were limited or nonexistent, that economic institutions extending beyond kinship probably developed. More specifically, these Middle Paleolithic people pioneered the crucial economic behavior of managing risk—in this case, the risk of starvation. They did it with two innovations: savings and group insurance. In the former case, they learned to put stores of food in secure places in their hunting and gathering territory, and then budget them to cover subsistence needs over the lean times. In the latter, nearby small kinship groups established social networks through alliance, intermarriage, visiting, and feasting that served as regional insurance policies. A group facing a decline in game (or lack of success in hunting) could make claims on the food stores of neighbors with whom they had previously invested time, attention, or their own food. This served to spread the risk of starvation over a broader number of hunters and gatherers, thus improving the chances of survival for all.

The concepts of savings and insurance are closely related; indeed, one might think of insurance as a way of realizing the benefits of savings without 1) having to develop technologies for saving food over a long period and 2) having to wait until a stock of savings is sufficiently large to tide a family or group over during hard times. Insurance-type arrangements, if they are of large enough breadth for their members to escape simultaneous misfortunes, represent a reasonable technique for coping with risk under difficult technological conditions.

The Upper Paleolithic, beginning about 50,000 years ago in various regions, represented the appearance of humans roughly identical to us today. It also brought two additional economic innovations of critical importance: specialization and investment. The Cro-Magnon and other advanced Homo sapiens of the Upper Paleolithic, unlike their predecessors, seem to have specialized in the hunting or gathering of specific species, rather than being purely opportunistic and pursuing whatever was visible in their range areas. Like savings and insurance, specialization was a form of risk management in the sense that it usually involved careful study of particular animals with the goal of predicting their behavior—and thus increasing the likelihood of catching them. Specialization took some of the risk out of hunting and gathering by allowing for the accumulation of knowledge with which small human societies could ensure a more stable and predictable food supply. It not only required study of animal habits and movements, but also a more detailed understanding of the climate and topography of their range areas.

Accumulating such knowledge had a cost. It took a great deal of time and effort, which earlier human societies had probably devoted to less taxing and more recreational activities. Indeed, many people assume that economic progress throughout history has meant a progressive increase in leisure time, but until recently the opposite has been true. In earlier Paleolithic groups, there was little to be gained by spending more time on hunting and gathering activities rather than on leisure activities. Hunting and gathering was such a hit or miss process that increased time and effort invested in it wouldn’t have yielded much more in the way of results.

But with the introduction of specialization, increased time and effort devoted to the study of quarry and environment could pay off in higher returns. So the more sophisticated hunters and gatherers of the Upper Paleolithic discovered the value of investment—forgoing consumption or leisure in the short run for greater material benefit in the long run. Until it became practical to store information (through better language skills and specialization in a relatively narrow field of inquiry) investment would have had paltry returns.

This revolution in hunting and gathering had repercussions beyond improvements in the food supply. It was also associated with the development of larger, multi-family groups. For one thing, specialization and investment made population growth much more desirable. Additional people meant additional opportunities to gather useful information and carry out the more complex strategies required to catch more game. At the same time, the improved food supply made it possible to support larger populations. Specialization and the increased scale of human populations led to larger and more permanent settlements, and the beginnings of a territoriality that would eventually lead to concepts of private property. And both the larger populations and the increased productivity of hunting and gathering made possible a greater division of labor within the groups, allowing some individuals the option of specializing in tasks other than hunting and gathering.

Savings and Investment Create Trade

Finally, the development of larger groups with a higher level of specialization created the conditions required to inaugurate trade among unrelated groups. After all, if one group chooses to specialize in a particular form of hunting and gathering, then the occasional acquisition of game or artifacts outside the specialty becomes more attractive. It represents variety and diversion. A coastal group specializing in catching fish and gathering shellfish would have something of value to offer an inland group specializing in hunting deer, horses, or other big game. This increased value of trade would apply not only to foodstuffs but also to other goods. In both western and central Europe of the Upper Paleolithic, for example, there is evidence that several species of seashells were traded or exchanged over hundreds of miles. Similarly, there is evidence of relatively long distance trade in high-quality flints and other raw materials.

The Upper Paleolithic Period ended with the end of the last Ice Age and the impact of global warming on the environment. The initial stages of this warming can be traced back to about 11,000 B.C., and affected different parts of the Old and New Worlds at different times. The oceans rose as ice melted, forests expanded over the expanses left behind by the retreating glaciers, and portions of the globe saw climate change of cold to temperate or temperate to hot. These changes led either to human migration or to significant changes in the way humans lived in their home areas. One further note about the end of the Upper Paleolithic is that it coincides with the final settlement of every habitable continent.

The key point for our purposes is that the development of multi-family societies, and later towns and cities, was based on the invention of economic practices involving delayed gratification, or savings. The habit of savings and investment paid its greatest returns once human settlements developed around new notions of private property. Once families could work their own land or tend their own herds, the economic value of hard work soared. After all, at a very basic level, agriculture and animal husbandry were the epitome of savings and investment. Rather than literally “eating the seed corn,” farmers planted it in the ground, tended it for months (perhaps nearly starving the whole time), and then reaped a far greater bounty at harvest time. With herders, delaying gratification meant feeding scarce grains and water to stock animals rather than to their own families. It meant tending, not eating, the stock. Those who could learn to do this would, in the long run, be far better off that those hunter-gatherers who worried only about today’s meal.

If one considers the broad sweep of human history, this radical revolution in how human beings live has occurred only recently. The passage of time from the last Ice Age and early human settlements to the modern day is, geologically speaking, a blink of the eye. Yet consider how radically different our lives are compared with our hunter-gatherer ancestors.

The Savings-Rate Decline

Although no data exist on the personal savings rate per se throughout recorded history, one can safely say that it was extremely high. Even as recently as the nineteenth century, most Americans still lived and worked on farms. They spent most of their waking hours saving and investing—working the land for the promise of future return. Few could afford luxury items, vacations, or other forms of current consumption.

The Industrial Revolution changed all that. Mass production, first of clothes and later of other goods, significantly reduced their cost and thus reduced the amount of time and effort consumers had to save and invest in order to afford them. Advances in transportation technology came next, facilitating trade and thus the comparative advantages in price and quality of purchasing goods from others rather than making them oneself. Finally, dramatic advances in agricultural technology and practices so increased the productivity of farming that prices fell, far more food and fiber could be produced per person, and farmers gradually found their time and effort more profitably invested elsewhere.

The purpose of savings and investment changed from acquiring basic necessities to addressing “quality of life” goals. As workers moved to cities, then to suburbs, in the new industrial economy, savings and investment became a means of purchasing a new automobile, buying a nice home, sending children to college, affording higher levels of health care, dealing with sudden disability or unemployment, and providing for a comfortable retirement.

Unfortunately, the advent of the New Deal in the 1930s, followed by the Great Society programs of the 1960s, began to suggest to Americans that these big-ticket items in their lives might be paid for by someone else. Roosevelt’s Social Security and unemployment insurance promised income in case of sudden loss of employment, disability, or old age. Johnson’s Medicare and Medicaid promised families that they wouldn’t have to save and invest to take care of elderly relatives who needed lots of medical attention or institutional care.

At the same time, these expansions of government spending required increasing amounts of revenue. The government got this revenue in large part by taxing private savings and investment. The first permanent income taxes arose in the early 1900s. Marginal rates soared during World War I and then rose again during the New Deal and World War II. Payroll taxes were added to fund entitlement programs, taking money that families would otherwise have saved for their own needs. Today, the income tax code is strongly biased in favor of current consumption and against long-term savings. For example, a worker who earns $1,000 will pay income and payroll taxes only once on that money if he chooses to spend it immediately. If he invests it in corporate stock, however, he will likely pay income tax on the money three or more additional times, as the corporation pays taxes on earnings, the worker pays taxes on his dividends, and then pays again if he leaves the investment to his heirs.

Is it any wonder that the rise of the welfare state has coincided with what many observers, of varying political persuasions, call a new ethic of instant gratification and self-indulgence? Public opinion polls show that Americans have become convinced that government will help them through the big expenses they will face in their lives, be it unemployment, education, health care, home-buying, disability, or retirement.

This is a mirage, of course. If one thinks of the money taxed out of families and “invested” by government for these future needs as the real rate of personal savings, then it’s not being invested very well. Everyone knows the crisis that faces Social Security in the long run, as Baby Boomers retire and base their expectations of a comfortable old age on the prospect of government transfer payments from a smaller cohort of working Americans. But the problem isn’t just limited to retirement. Medicare will go broke far earlier, perhaps in the next decade. Medicaid—increasingly a program of nursing-home payments for the middle-class elderly instead of an anti-poverty program—will collapse next. Unemployment insurance is already an awful deal for most workers, who are eligible to draw money only if they are terminated without cause, and even then they get paltry returns. The money Americans are forced to save and invest in education also gets poor returns, as the mediocre test scores of American schoolchildren and the declining academic standards of American universities illustrate.

So even if one defines the savings rate in the most expansive manner—as not only private savings but also the amount of money government “saves” on your behalf—there remains a savings crisis. Too little of our seed corn is being invested in long-term productive enterprise, with a promise of future harvests. Instead, government is feeding this seed corn to current beneficiaries of entitlement programs. Americans have lost the impulse that industrious human beings throughout history have maintained to work and save for the future.

This is the real savings crisis. It isn’t just one of dollars and cents, but of thrift and self-reliance. The solutions are clear: end the tax code’s bias against private savings and investment, and end government’s false promise of saving and investing on our behalf. There is no more serious challenge facing American society and American freedom.

(For further background, see Barry Cunliffe, The Oxford Illustrated Prehistory of Europe (Oxford: Oxford University Press, 1994) and Mark Kishlansky, Civilization in the West, Volume 1 (New York: HarperCollins Publishers, 1991).

Inflation mixes worthless dollars with the sound dollars of a productive economy. The dol­lars inflation puts into pay enve­lopes add nothing but higher price tags on things.’

I yield to no man in the world in a hearty goodwill towards the great body of the working classes, but my sympathy is not of that morbid kind which would lead me to despond over their future prospects. Nor do I partake of that spurious humanity which would indulge in an unreasoning kind of philanthropy at the expense of the great bulk of the community. Mine is that masculine species of charity which would lead me to inculcate in the minds of the labouring classes the love of independence, the privilege of self-respect, the disdain of being patronised or petted, the desire to accumulate, and the ambition to rise. I know it has been found easier to please the people by holding out flattering and delusive prospects of cheap benefits to be derived from Parliament rather than by urging them to a course of self-reliance, but while I will not be a sycophant of the great, I can­not become the parasite of the poor.

Richard Cobden, 1836

Foot Notes

¹ Inflation is an increase in the quantity of money, not a rise in prices which is only the consequence of inflation.

²They are worse off, in fact, but the reasons are beyond the scope of this discussion.

³ In calculating the $29.99 rate, I am assum­ing that in the year 2012 his work will cor­respond to that of present laborers in the petroleum and coal industries.

⁴Based on 40-hour week and vacations with Pay.

⁵Figures provided by a leading insurance company. The plan is the usual pension Plan, invested mainly in bonds, mortgages, and the like.

⁶ White, Andrew Dickson. Fiat Money Infla­tion in France, Irvington -on-Hudson, N. Y.: The Foundation for Economic Education, Inc., 1962. pp. 32, 65-66.

Real wages in the United States are about five times as high as they were a century ago. The first in this series of articles showed that this rise apparently is not, as commonly believed, due to the growth of labor unions.

The second article in the series showed the close parallel between changes in incomes and productivity. Higher wages come from increased output per hour of work. This is not a new or profound discovery. For how could consumption be greater than production?

Wages, however, are not the only part of the economic pie. Why, then, couldn’t wages be raised by giving the employee a larger share? That is the question to be dealt with in this article.

For purposes of this discussion, the pie of personal incomes may be thought of as divided into two parts. One is the pay for work done currently and the other is pay for the use of savings—income from work done in the past and not used for consumption at that time.

Pay for work done currently includes wages and salaries, or the equivalent in some other form of economic reward. On the other hand, income from the use of savings includes interest on money loaned, dividends on shares of ownership, rent on real estate, and the like.

A person who has never saved a cent and who owns no tools of his own may be getting all his income from work done currently, using tools that have been provided by the savings of others. Another person—perhaps an aged person—may be idle so far as current economic effort is concerned, getting all his income as pay for the use of his past savings. More commonly, a person receives part of his income from each of these sources, getting some from current effort and some from savings.

Some persons work for themselves, using in full or in part tools provided from their own savings. And some persons work for others.

There are all sorts of combinations of income from these two sources. But in some form or degree, essentially everyone in the United States has savings or property and is therefore a capitalist. Most persons also have some income from work done currently.

Present Divisions of the Pie

Information about the present division of the economic pie can be found in figures supplied by the Department of Commerce.^*

The average personal income in the United States was about $4,600 in 1955. Of this amount, something like 85 per cent, or $3,910, appears to have been pay for work done currently. The remaining 15 per cent, or about $690, was pay to savers who were providing the tools of production in one form or another.

Were the entire pie to go to wage earners and others as pay for current work—as advocated by Karl Marx, to be explained shortly u wages could go up from 85 to 100, or about one-sixth. And even this much rise could occur only if there were no reduction in the size of the total pie—that is, in total production.

But let’s assume that no decline were to occur in total production. How important, then, would be the rise in wages compared with the rise caused by increased productivity which was discussed in the two previous articles? Since 1917, wage rates have risen with increased productivity at about 2.5 per cent a year. Thus in six years’ time this rise in wages would equal the 15 per cent increase possible from getting all the remainder of the pie. Or to put it another way, productivity increases during the past working generation have raised wages perhaps six times as much as could possibly come from diverting to wages every cent of current returns for savings.

Wages can, furthermore, continue to rise indefinitely so long as productivity continues to increase. But a gain in wages from a larger share of the pie is a gain which can be repeated only once. Any increase from that source can go only from the 85 to 100 per cent, and no further. A dead end to improvement is then reached, because a pie of more than 100 per cent is not possible.

Adverse Effects on Savings

Capital created from savings makes possible a large part of our production. It apparently raises the average income in the United States to a level of $4,600 instead of perhaps $200 to $250—as it would be if there were essentially no tools. This teamwork between those who save and those who use the tools is the reason for our high and rising wage rates. Without a continuous and increasing supply of tools, the gear wheels of economic progress would be slowed or even stopped.

Without a return for savings, where would future tools come from to enhance the fruits of current effort? Who would then be willing to save and invest in tools, if obliged to take all the risk without any prospect of return? Few persons would save till tomorrow what they could consume today, unless they were rewarded for doing so.

During the last quarter century inroads have been made into the reward for savings, with serious consequences. The rate at which personal savings are being invested in productive tools, as compared with earlier decades, has declined. Among what we call “savings” are government bonds, which in reality are investments in a deficit of the government—not a productive tool any more than would be your tax receipt. And some of what is called “savings” has been forced upon individuals, in a sense, as a direct or indirect consequence of present tax policies.

Over the last quarter century the costs of government have nearly trebled in proportion to personal incomes, going up from 12 to 34 per cent. It is impossible, of course, to know for certain how heavily this has been a burden on pay for savings as compared to pay for current work. But there have been large increases in the graduated taxes on both individual incomes and corporate incomes—the “double tax”—and the government has held down interest rates in order to help the sale of its (deficit) bonds. This has unquestionably reduced the share of the pie going as pay for real savings.

History of an Idea

An increased share of the pie going to wages, at the expense of the share for savings, is not just an accident. It is the wayward son of a notorious ideological ancestor. Its pedigree needs critical study by those of us who have faith in a system of personal responsibility and freedom of opportunity in economic affairs. Plausible on the surface, this idea has seduced many who today denounce it by name but embrace its substance.

During most of his ten million or more years of history, man has presumably been his own employer, producing most of his own food, raiment, and shelter—though, of course, we do not know the unknown. But if it is true that in most instances he worked for himself, or perhaps joined other huntsmen and producers in informal cooperation, such a type of livelihood would hardly have permitted him to embrace the notion that one’s welfare can be ira-proved by claiming a larger share of his own pie. No sane person is going to demand more wage from himself for his muscular work, at the expense of his management self or his tool-owning self.

Somewhere along man’s historic trail some men began to enslave others to work for them. Slaves doubtless wanted a larger share of what was produced, but there wasn’t much they could do about it because the master held full ownership of the slave. And anyhow, in those early slave-holding days each person was able to produce little more than enough to keep himself from starving, and so a master couldn’t take much of what a slave produced or he would have a slave no more.

In more recent times the voluntary employer-employee arrangement among free men has largely displaced slavery throughout the world. Some work for others at a wage. They may want to do so as a way of gaining the use of tools with which to work, or because for some other reason the wage offered is more enticing than the rewards in prospect while working for themselves.

By this arrangement, persons sell in the market what they have jointly produced. And when this is done, the problem of dividing the pie arises in a new form. Instead of a slave who can do nothing about it except bemoan his plight as he wearily hoes his row, the employee can—if he so desires—go elsewhere to seek an easier livelihood or higher pay.

Labor and Surplus Value Theories

From this new economic climate there arose, in the course of time, the labor theory of value which has become highly appealing to some among the employee class. It is often used in one way or another in bargaining for wages, which are now a form of price and therefore the object of higgling and haggling in the market, as is the price of wheat or potatoes.

On its surface the labor theory of value seems plausible enough. Suppose you are a self-employed person and consume what you produce. If you have to work twice as long to produce one thing you want as to produce another, it would seem that you must prize the former twice as much as the latter. If this were not so, wouldn’t you have produced something else instead? Something requiring three times the labor must be prized three times as much, etc. In like manner, the labor theory of value assumes that labor is the essential ingredient by which to measure all value.

The labor theory of value had just nicely gained some respectable acceptance among economists of that early day when along came a man—Karl Marx—with a cause which fitted this theory tragically well. Others before Marx had, of course, held essentially the same views about value. But Marx set in motion forces which have brought the world to the brink of disaster in economic, social, and political affairs.

Having accepted the labor theory of value from the classical economists, Marx a century ago attempted to explain how profit to private owners worms its wily way into exchange by way of the capitalist system. All return on capital, according to Marx, comes out of the value that labor has created and is just another form of theft that capitalism has tried to make respectable. This concept of profits is a logical descendant of the labor theory of value.

Marx viewed a return on capital in the same manner as a doctor views a parasite feasting on his patient. For if all value comes from labor and is in proportion thereto, any share of the pie going to anyone other than the laborer, in proportion to his labor, must be the result of a parasitical attachment by capitalists.

The devilment in the capitalist setup, according to Marx, is made possible by the private ownership of the land, materials, and tools with which labor does its work. The capitalist owner who holds title to these material means of production can, in this way, claim ownership of the product. He can then withhold any part of it he wishes from the laborer—the one who Marx claimed was the rightful owner of all of it because he is the one who created all its value in the first place.

So pay for the use of capital is like loot from theft, as Marx saw it. He said that the absolute amount of profit is equal to the absolute amount of surplus value. Persons who hold these Marxian beliefs charge that the laboring man is “exploited” by the capitalist owner; that he is a “wage-slave” of the capitalist.

The term surplus value was defined by Marx, then, as the part of production which, under private ownership, is confiscated by the capitalist from its rightful owner, the laborer. That is the part which all Marxians believe can and should be reclaimed by labor. The amount of surplus value, by this concept, measures the amount that wages could rise aside from any increase in hourly output. Were labor to regain this lost part of the economic pie, it would simply mean taking it back from the capitalist thief.

Some ten million years ago man’s tools probably were simple ones, like a stone fastened to the end of a stick. We may assume incomes then were essentially all reward for current work, rather than being a reward for savings from past effort stored in the form of tools to aid in production. The labor theory of value may seem to have applied fairly well then because essentially all production was the result of direct and current labor. True or false, the surplus value theory could hardly have been of concern then, and putting it into practice could have done little damage to their meager living.

But today, being as dependent as we are on tools, the surplus value theory is a sort of economic bomb which, if infused into action, could do unbelievable damage. Were the “justice” of that theory to be put into practice, we would probably be writing articles about why wages fall rather than why wages rise.

The problem of dividing the pie should be left to the free market of individual choices among employees and employers; consumers and producers; investors and borrowers; traders of all sorts, everywhere in exchange. If left to these free individuals, rather than to become the handles of power in politics or among organizations representing any of these special interests, the decisions will be in the best interests of all.

Wherever the pie is divided by the free market, one thing seems sure: Marx’ surplus value theory will be vetoed. For persons will continue, as they have over the past few centuries in our relatively free United States, to recognize a bargain when they see one. That bargain is tools. Of our total output, perhaps as much as 95 per cent is because of the use of tools. And this is at a cost of only about 15 per cent of total output, as pay to those who have saved to create these tools. That, and not Marx’ concept, is the miracle that creates a surplus of value.

In the next article I propose to show how it has been possible for savings to increase production as much as they have.

Foot Notes

* Survey of Current Business, National Income Number, July 1955, and corresponding issues in earlier years. United States Department of Commerce.