Criticizing Savings-Based Economic Growth

This article will argue that savings is not the only component of economic growth. This article will not argue against the idea that savings contributes to growth, but will argue instead that savings must not be the only or ultimate determinant of growth.

Economic growth is observed to be exponential. This creates a problem for economic models because there are diminishing marginal returns to both labor and capital. Even when combined in an ideal way, a model built with these two alone would produce a linear growth model.

Therefore we add another variable to the Cobb-Douglass equation. The variable is called <a href="http://en.wikipedia.org/wiki/Total_factor_productivity">TFP, or total factor productivity. This variable does two things:

1. Allows our model to be theoretically precise by acting as an error term. If capital and labor fail to explain an abnormality, we lump it in to TFP. It is total because it addresses all factors, other than labor and capital.
2. Allows us to investigate and understand the determinants of exponential economic growth by analyzing what causes, or at least correlates, with changes in TFP. Holding capital and labor constant, change in TFP means change in total economic product, Y, or GDP, for one example of how to measure the total economic product.

No one exhaustively knows what causes or correlates with TFP. Neoclassical economists attribute a large part of TFP to technology. TFP can be seen as a stock of technology, where the TFP growth rate represents the growth rate of technology.

Austrians believe in savings based economic growth, but I will argue that while they are a little bit correct, they only explain a small portion of actual economic growth.

Austrian economic growth occurs in the following way:

1. The savings rate is increased.
2. There is an increase in the supply of loanable funds.
3. The increased supply of loanable funds leads to a decrease in the real interest rate.
4. The decreased real interest rate allows new projects to occur in at least 2 ways. Many Austrians don't even discuss this. They will refer to a restructuring of the economy according to the Hayekian triangle, but really they need a Hayekian (or Vandivierian?) Pyramid or Triangular Prism. Consumption moves toward future goods, as Hayek notes, but future goods are increased in 2 distinct ways, which I've only heard 2 Austrians ever note; Professor Hardee of the University of Texas, and Jesús Huerta de Soto, where she claimed to have gotten the idea from (unless I misunderstood them both):
   1. Productive Widening: Low-cost business opportunities flourish because the reduced interest rate makes them profitable. There is an increase to the supply of all current goods.
   2. Productive Deepening: Super-high costs business opportunities, which were previously cost prohibitive become cost feasible.
5. Prices drop in three ways:
   1. Increased general supply causes decreased general prices.
   2. Increased development of technology, as technology can be seen a product, causes increased efficiencies.
   3. New, more efficient productive processes can occur with the additional financing due to economies of scale and productive deepening.
6. With decreased prices, everyone can save even more while maintaining a constant, or possibly even a better, standard of living. Therefore, the growth is real, or sustainable, economic growth.

I agree with this sustainable cycle of economic growth, but there are at least 4 problems with this story:

1. Savings can never be maximized. If savings were 100% people would starve to death.
2. So the Austrian solution cannot be to save everything. It must be to save as much as possible. I will call this the Austrian Golden Rule Savings Rate, in contrast to the Neoclassical Golden Rule Savings Rate, which is the savings rate to maximize growth of consumption. If either of these ideological schools would put their solutions to the side and model reality, they would realize that people are going to have unique savings patterns which maximize neither short-term consumption nor long-term growth, but personal preference which almost certainly lays somewhere in between. Perhaps the Austrian or Neoclassical models can forecast efficient action decisions, but neither will be able to forecast actual action decisions until this is corrected for.
3. Historically, a constant savings, or even a decreased savings rate, has from time to time seen real per capita GDP growth. It seems that saving may increase the growth rate, but not saving doesn't mean there is no growth. There are at least some confounding factors.

Empirically and theoretically, income does not directly cause innovation. When I get a raise I do not become smarter. This is almost exactly backwards of real life. A person with no income at all can still innovate. Crusoe, for example, innovates not only by producing his net to catch fish, thus saving labor-hours, but by self-teaching to fish in the first place. It seems income is the output of technology, not vice versa.