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Saving, consumption and investment relationships - GDP identities

Second comments on Mario Lamberte “Some positive consequences of the Global Economic Crisis”, 1/06/2009, http://www.eastasiaforum.org/2009/06/01/some-positive-consequences-of-the-global-economic-crisis/

This is my second comments on this article, but still a very brief one. I just make two quick points here. One is the different presentations of the GDP and the other is about trade and external shocks.

Firstly, the different presentations of the GDP identity. The following is two of the different measures of GDP:

C + I + G + E -M = Y = C + S + T + Rf

Where Rf is net transfer to other countries and all others are as their normal representations. (for a reference to the above identities, see http://www.econ.ilstu.edu/hmohamma/441/lectures/lecture_02.htm).

If one looks only at the right hand side, it is easy to be confused by the inevitable trade off between savings and consumption, a point made in that article. But if one looks at the left hand side, one can easily see that to address high propensity to save, it is not necessarily to increase consumption. Instead, an increase in investment can accommodate high savings. Indeed, in conventional cases, savings are generally equal to investment in a closed economy. So, if there are investment opportunities in an economy, to invest the savings can be an effective way and likely a better way than increasing consumption, especially when capital is comparatively scarce, as in most developing economies in Asia. That is way I found either myself is so dumb in unable to understand the point in the article, or the point in the article is so ill conceived to mention only the increase of consumption and little about investment to accumulate capital.

Secondly, the role of trade in a modern economy. Let’s have a look at the left hand side of the GDP identity above. What Lamberte was concerned is that exports, E may not be growing as fast as it had been prior to the current world economic crisis because the US and Europe are in serious trouble and the US will need to adjust its savings and consumption. As a result, the trade / current account balance may not contribute to economic growth for many Asian economies, so the argument went.

It is possible that may be the case for the foreseeable period in the near future. But it is by no means a completely foregone conclusion. The US needs to increase its savings, both private and public. But that may not necessarily mean that their absolute levels of consumption and government spending will always fall to realise that. It may be a long and slow adjustment process, in which private consumption and government may still rise but at a slower pace than its GDP. That is to say, the proportion of the net increase in GDP devoted to savings will be larger than its existing actual proportion, but there will still some left for an increase in consumption and government spending.

Second, trade with the US may still be able to expand even when the consumption in the US is not to increase but to stay constant or even fall. The requirement is an increase in the so called intra-industry trade. There is no requirement that economic growth is the necessary condition for trade expansion.

Third, assuming that the US has ceased to be an engine of the world economic and trade growth, then other economies may take a greater role in the expansion of world economic and trade growth. Yes, it would be nice if the US could indefinitely absorb exports of other economies, especially from Asian ones. But the pattern of the world economy has been changing and the contribution of the US to world economic and trade growth, though very important as it has been, has been on the decline and will continue to do so, and even at an increasing pace.

That itself does not equate to a call for the developing economies in Asia to increase their consumption to boost their growth. To the contrary, given the role of capital in economic growth and the relatively low levels of per capita physical capital in those developing economies, the most effective way seems to be to increase investment rather than to increase the proportions of consumption, for long term growth and catch up.

That is why I find it difficult to understand there are so may people, both economists or not, high ranking officials and advisers included, are calling for China and other Asian developing economies to increase their consumption to solve the so called international imbalance. Can’t we just simply have a look at the GDP identities and to have a sense of what is needed for economic development and catch up for developing economies? There are not too many variables there. Is that too difficult to do or comprehend? Why?

Let’s have a debate!

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