Economy
Capital, Savings, and Investment

In the United States and in other market economies, financial firms and markets channel savings into capital investments. Financial markets, and the economy as a whole, work much better when the value of the dollar is stable, experiencing neither rapid inflation nor deflation. In the United States, the Federal Reserve System functions as the central banking institution. It has the primary responsibility to keep the right amount of money circulating in the economy.

Investments are one of the most important ways that economies are able to grow over time. Investments allow businesses to purchase factories, machines, and other capital goods, which in turn increase the production of goods and services and thus the standard of living of those who live in the economy. That is especially true when capital goods incorporate recently developed technologies that allow new goods and services to be produced, or existing goods and services to be produced more efficiently with fewer resources.

Investing in capital goods has a cost, however. For investment to take place, some resources that could have been used to produce goods and services for consumption today must be used, instead, to make the capital goods. People must save and reduce their current consumption to allow this investment to take place. In the U.S. economy, these are usually not the same people or organizations that use those funds to buy capital goods. Banks and other financial institutions in the economy play a key role by providing incentives for some people to save, and then lend those funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings institutions pay interest to people who deposit funds with the institution, and borrowers pay interest on their loans. Like any other price in a market economy, supply and demand determine the interest rate. The demand for money depends on how much money people and organizations want to have to meet their everyday expenses, how much they want to save to protect themselves against times when their income may fall or their expenses may rise, and how much they want to borrow to invest. The supply of money is largely controlled by a nation’s central bank—which in the United States is the Federal Reserve System. The Federal Reserve increases or decreases the money supply to try to keep the right amount of money in the economy. Too much money leads to inflation. Too little results in high interest rates that make it more expensive to invest and may lead to a slowdown in the national economy, with rising levels of unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses, and government—only households are net savers. In other words, households save more money than they borrow. Conversely, businesses and government are net borrowers. A few businesses may save more than they invest in business ventures. However, overall, businesses in the United States, like businesses in virtually all countries, invest far more than they save. Many companies borrow funds to finance their investments. And while some local and state governments occasionally run budget surpluses, overall the government sector is also a large net borrower in the U.S. economy. The government borrows money by issuing various forms of bonds. Like corporate bonds, government bonds are contractual obligations to repay what is borrowed, plus some specified rate of interest, at a specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and firms that are creditworthy—meaning they will be able to repay the loans. The creditworthiness of the borrower is one reason why some kinds of loans have higher rates of interest than others do. Short-term loans made to people or businesses with a long history of stable income and employment, and who have assets that can be pledged as collateral that will become the bank’s property if a loan is not repaid, will receive the lowest interest rates. For example, well-established firms such as AT&T often pay what is called the bank’s prime rate—the lowest available rate for business loans—when they borrow money. New, start-up companies pay higher rates because there is a greater risk they will default on the loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and other lenders charge different rates of interest. Mortgage loans are backed by the collateral of the property the loan was used to purchase. If someone does not pay his or her mortgage, the bank has the right to sell the property that was pledged as collateral and to collect the proceeds as payment for what it is owed. That means the bank’s risks are lower, so interest rates on these loans are typically lower, too. The money that is loaned to people who do not pay off the balances on their credit cards every month represents a greater risk to banks, because no collateral is provided. Because the bank does not hold any title to the consumer’s property for these loans, it charges a higher interest rate than it charges on mortgages. The higher rate allows the bank to collect enough money overall so that it can cover its losses when some of these riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of business. The effects of bank failures on depositors and the overall economy can be very severe, especially if many banks fail at the same time and the deposits are not insured. In the United States, the most famous example of this kind of financial disaster occurred during the Great Depression of the 1930s, when a large number of banks failed. Many other businesses also closed and many people lost both their jobs and savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not want to lose money or go out of business, and they try to avoid making loans to individuals and businesses who will be unable to repay them. In addition, a number of safeguards protect U.S. financial institutions and their customers against failures. The Federal Deposit Insurance Corporation (FDIC) insures most bank and savings and loan deposits up to $100,000. Government examiners conduct regular inspections of banks and other financial institutions to try to ensure that these firms are operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is the low household savings rate in this country, compared to that of many other industrialized nations. People who live in the United States save less of their annual income than people who live in many other industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and several factors are often discussed. U.S. citizens may simply choose to enjoy more of their income in the form of current consumption than people in nations where living standards have historically been lower. But other considerations may also be important. There are significant differences among nations in how savings, dividends, investment income, housing expenditures, and retirement programs are taxed and financed. These differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts as much as they do other forms of income, and some countries do not tax at least part of the income people earn on savings accounts at all. In the United States, such favorable tax treatment does not apply to regular savings accounts. The government does offer more limited advantages on special retirement accounts, but such accounts have many restrictions on how much people can deposit or withdraw before retirement without facing tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they pay on mortgages for the homes they live in. That encourages people to spend more on housing than they otherwise would. As a result, some funds that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the Social Security system, the government program that provides some retirement income to most older people. The money that workers pay into the Social Security system does not go into individual savings accounts for those workers. Instead, it is used to make Social Security payments to current retirees. No savings are created under this system unless it happens that the total amount being paid into the system is greater than the current payments to retirees. Even when that has happened in the past, the federal government often used the surplus to pay for some of its other expenditures. Individuals are also likely to save less for their own retirement because they expect to receive Social Security benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with fewer dollars available as savings to banks and other financial institutions, interest rates are higher for both savers and borrowers than they would otherwise be. That makes it more costly to finance investment in factories, equipment, and other goods, which slows growth in national output and income levels. Second, the higher U.S. interest rates attract funds from savers and investors in other nations. As we will see below, such foreign investments can have several effects on the U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more investments in capital goods, but it also creates concerns. For example, in order for foreigners to invest in U.S. savings accounts and U.S. government or corporate bonds, they must have dollars. As they demand dollars for these investments, the price of the dollar in terms of other nations’ currencies rises. When the price of the dollar is rising, people in other countries who want to buy U.S. exports will have to pay more for them. That means they will buy fewer goods and services produced in the United States, which will hurt U.S. export industries. This happened in the early 1980s, when U.S. companies such as Caterpillar, which makes large engines and industrial equipment, saw the sales of their products to their international customers plummet. The higher value of the dollar also makes it cheaper for U.S. citizens to import products from other nations. Imports will rise, leading to a larger deficit (or smaller surplus) in the U.S. balance of trade, the amount of exports compared to imports.

Foreign investment has other effects on the U.S. economy. Eventually the money borrowed must be repaid. How those repayments will affect the U.S. economy will depend on how the borrowed money is invested. If the money borrowed from foreign individuals and companies is put into capital projects that increase levels of output and income in the United States, repayments can be made without any decrease in U.S. living standards. Otherwise, U.S. living standards will decline as goods and services are sent overseas to repay the loans. The concern is that instead of using foreign funds for additional investments in capital goods, today these funds are simply making it possible for U.S. consumers and government agencies to spend more on consumption goods and social services, which will not increase output and living standards.

In the early history of the United States, many U.S. capital projects were financed by people in Britain, France, and other nations that were then the wealthiest countries in the world. These loans helped the fledgling U.S. economy to grow and were paid off without lowering the U.S. standard of living. It is not clear that current U.S. borrowing from foreign nations will turn out as well and will be used to invest in capital projects, now that the United States, with the largest and wealthiest economy in the world, faces a low national savings rate.