Growing where

As the economy grows, much of the extra cash may not be spent

We all change as we grow, and this is also true of the economy. With incomes typically rising with economic growth, what we tend to buy changes as well, and this shift in spending also goes on to shape what is produced when we are at work. What we normally think of as the economy typically revolves around things to consume but increasingly money goes towards buying into investments. While this trend is given little attention within economic theory, it is perhaps having a bigger impact than is thought.

There has been a change to the things that we buy as economic growth has progressed. With more people earning bigger pay checks, spending is shifting from things that we need here and now to money put away for the future. Like most things in the economy, more demand for places to put away cash has resulted in an increasing range of options of what to invest in. A whole industry has been built up on providing investment products for those with money where ever they might live.

In the past, any money stashed away as savings in the bank didn’t really earn much. The financial deregulation that started in the 1980s changed this with an increasing emphasis on money being put to work. More choice about where your cash could go also meant that funds could better be directed to areas of the economy where it could be put to the best use. Along with the extra cash to be made by investors, those who played their part in moving money around also got paid well for their role.

Economic theory would suggest that any money put aside is beneficial as it frees up important capital to be used by businesses to expand profitable ventures. Yet, the reality seems to be that many of the large companies have a surplus of cash, much of which is used in share buybacks rather than investing in new business. And banks no longer rely on deposits to issue loans to smaller businesses as they might have done in the past. Rather than going towards supplying goods and services to sell, funds for investment often go into buying an asset that someone else owns and wants to sell. This asset could be a stock or a bond but could also be a property or something more exotic like an artwork or vintage bottle of wine.

It can be assumed that demand for such investments must be growing as the prices for things that people buy to invest in are increasing. Rising demand seems intuitive as greater levels of wealth mean that there is more money available to be invested. For prices to rise, it is not enough for demand to be high but also that supply must be unable to keep up. It seems to be the case that coming up with new ways of making money from money is not that easy. Excess demand is most notable for less riskier investments with some investors prizing safety so much that they are willing to tolerate negative returns on some government bonds.

This trend might be something that is inherent to capitalism and will continue to build up over time. But there are also factors that are not permanent which may mean that demand may ebb away in the future. For example, less money might go into investments due to selling brought on by the retirement of the baby boomer generation who have built up financial assets to provide them with income into their old age. Also, some countries, such as China, also generate surplus capital that is channelled into foreign financial markets but these flows may dry up once options for investing in their domestic markets increase.

Whatever the source of excess demand, the resulting rising prices for financial assets contrasts with the relatively weak demand for goods and services in the underlying economy and the low levels of consumer price inflation. It may be the case that funds diverted towards investment tends to take money away from spending on goods and services which may have contributed to subdued inflation. After all, higher earnings are not likely to translate into more and more consumption, while investments can continue to mount up as incomes rise.

The increasing amounts of money going into investment products has the potential to change the way money flows around the economy. Normal consumption involves buying things that would have been made elsewhere and transported to the location of sale where staff wait to provide assistance. Or it may involve a service whereby an output is provided by someone on request. Purchasing goods and services thus typically involved substantial amounts of labour enabling a wide range of people to earn a pay packet.  

Investment products do involve some labour but the amount of input involved is usually relatively small especially considering the large sums that are typically involved. The workers involved are also concentrated, both in terms of geographical space (financial centres such as New York or London) but also with regard to the type of workers (educated and white-collar). Their spending could also be seen as being different to the average worker such as more money flowing to other places through, for example, the purchase of imports.

While the production of investment goods is narrow in its scope, the benefits from the money put away are also mostly captured by those owning the assets rather than being spread out through the whole economy. Higher asset prices do not serve any economic purpose (an increase in the cost of buying property should increase the number of houses being built but often doesn’t) but instead just results in a shift of funds to the owners of the assets. This issue is likely to worsen as the gap between those who have and do not have money in investments expands as financial assets are becoming pricier while wages (which cannot grow much faster than consumer inflation) are relatively flat.

On top of this rise in inequality and its economic consequences, a bigger finance industry is also problematic in terms of being a source of instability in the economy as seen in the dotcom bubble and the global financial crisis. Growing disparities in earnings also create problems in terms of social cohesion and can impact negatively on the political system. Another potential issue is the effect on aggregate demand in the economy. Not only is potential spending diverted into investment but the extra income going to the wealthy is less likely to be spent. This is because those with high earnings are likely to spend less when provided with more cash to spend compared to people on lower incomes.

The obvious conclusion from this trend is that asset prices will continue to rise as more money gets drawn into investment products unless there is a dramatic shift in either demand or supply. Such a trend would impact on how the economy functions and thus on attempts by policymakers to manage economic booms and busts. For example, the abilities of central banks would also likely suffer as measures such as quantitative easing (designed in part to boost asset prices) would have a diminishing effect. As already mentioned, boosting the earnings of holders of investment has less impact on overall spending and so monetary policy often struggles to gain traction.

Such difficulties have resulted in a recent shift to give greater emphasis on fiscal policy which allows for money to go towards people more likely to spend it rather than add it to their stockpile. Further government action might be necessary to avoid an economy where wealth continues to grow faster than incomes. Such was also the case around a century ago and it took unprecedented social and political change for wage-earners to make up lost ground and broader economic growth to take hold. With the value of investments climbing higher while prices for other things remains relatively flat, it is not obvious what it might take to (yet again) rebalance the economy and where, left to its own devices, economic growth might be heading.