In a simple economy, with no government and no foreign trade, economic activity (the GDP) can only remain at a stable level if everyone spends all their income.
Why?
Because if they don't spend all their income but instead save some then they deprive other parties of income. These other parties then have to cut down on their purchases. The original sellers will experience a reducing in sales and therefore receive less income. To be succinct: if you represent the entire economy your spending today is your income tomorrow. Cut spending and you cut your income.
Understanding this basic principle is so important that I will illustrate it with an example. Imagine that the economy consist only of two people, one producing food (the food guy) and the other drink (the drink guy). Imagine that they have 1 dollar between them, which is 'the money supply'. To start things off the drinks guy has the dollar and he uses it to purchase food from the food guy, which enable the food guy to use this dollar to purchase drink. With this income the drink guy can once again buy food. This purchasing cycle can continue indefinitely with economic activity at a stable, constant rate.
Now imagine the drinks guy decides he would like a few days off occasionally. This is only possible if he saves some of his income from selling drinks to spend on food on his days off, when he won't receive any income because he won't be selling drinks.
In order to save he decides not to spend his entire 1 dollar income on food. Instead he spends only 75 cents and saves 25 cents. But this means that the food guy only earns 75 cents so he can only buy 75 cents worth of drinks the next day. The drinks guy is disappointed that his sales (and therefore income) have dropped from $1/day to 75p/day but decides to still save 25 cents of this and spends 50 cents on drink. However the next day he finds he only sells 50 cents worth of food (because that is all the drinks guys has received in income). He realises he can't save any of this so now he spends 50 cents. Now he and the drinks guy continue trading but at only half the level - 50 cents/day. Economic activity has dropped by 50% simply because one of the parties has decided save some of his income.
This propensity of individuals and companies to save is a form of demand leakage. Another source of demand leakage is net imports - where some of our spending is diverted outside our economy. Demand leakages WILL cause economic activity to contract unless the missing demand is replaced.
Government tax policies actually promote demand leakage by making contributions to pensions tax deductible. This provides a strong incentive to make pension contributions from your income (i.e. save) instead of spending. Apart from suppressing demand these tax incentives for saving channel huge amounts of money into the financial sector.
There are three possible sources of demand to fill the gap caused by demand leakage.
1. From outside the country - increasing exports to other countries. This is easier said than done. Moreover, not every country can be a net exporter. Not until we find markets on other planets.
2. From credit expansion by bank lending. This has been the main source of demand compensating for demand leakages in the past 4 decades. It has resulting in excessive private sector debt and an asset price bubble, the collapse of which precipitated the current crisis. Now this debt has to be paid off. Clearly credit expansion can no longer be relied on to plug a demand leakage. Instead there is a powerful desire to save which is likely to last until private sector debt are at sustainable levels.
3. From the government sector. Demand leakages can be filled by deficit spending. This is when the government sector spends more into the the economy than it extract through taxes. Spending injects demand and taxation subtracts it. That is why tax cuts are a powerful economic stimulus.
Unless countries are net exporters, like Germany, deficit spending is required just to maintain economic activity at a steady state (i.e. no growth). In the absence of net exports the level of deficit spending needs to match the level of net private savings (savings - investment) just to prevent the economy from shrinking. If a country is net importer the budget deficit needs to equal net imports plus net private sector savings just to prevent a recession.
This is another illustration of how deficit spending is usually essential in an economy, since most economies have demand leakages as the private sector tries to save.
Understanding this basic principle is so important that I will illustrate it with an example. Imagine that the economy consist only of two people, one producing food (the food guy) and the other drink (the drink guy). Imagine that they have 1 dollar between them, which is 'the money supply'. To start things off the drinks guy has the dollar and he uses it to purchase food from the food guy, which enable the food guy to use this dollar to purchase drink. With this income the drink guy can once again buy food. This purchasing cycle can continue indefinitely with economic activity at a stable, constant rate.
Now imagine the drinks guy decides he would like a few days off occasionally. This is only possible if he saves some of his income from selling drinks to spend on food on his days off, when he won't receive any income because he won't be selling drinks.
In order to save he decides not to spend his entire 1 dollar income on food. Instead he spends only 75 cents and saves 25 cents. But this means that the food guy only earns 75 cents so he can only buy 75 cents worth of drinks the next day. The drinks guy is disappointed that his sales (and therefore income) have dropped from $1/day to 75p/day but decides to still save 25 cents of this and spends 50 cents on drink. However the next day he finds he only sells 50 cents worth of food (because that is all the drinks guys has received in income). He realises he can't save any of this so now he spends 50 cents. Now he and the drinks guy continue trading but at only half the level - 50 cents/day. Economic activity has dropped by 50% simply because one of the parties has decided save some of his income.
This propensity of individuals and companies to save is a form of demand leakage. Another source of demand leakage is net imports - where some of our spending is diverted outside our economy. Demand leakages WILL cause economic activity to contract unless the missing demand is replaced.
Government tax policies actually promote demand leakage by making contributions to pensions tax deductible. This provides a strong incentive to make pension contributions from your income (i.e. save) instead of spending. Apart from suppressing demand these tax incentives for saving channel huge amounts of money into the financial sector.
There are three possible sources of demand to fill the gap caused by demand leakage.
1. From outside the country - increasing exports to other countries. This is easier said than done. Moreover, not every country can be a net exporter. Not until we find markets on other planets.
2. From credit expansion by bank lending. This has been the main source of demand compensating for demand leakages in the past 4 decades. It has resulting in excessive private sector debt and an asset price bubble, the collapse of which precipitated the current crisis. Now this debt has to be paid off. Clearly credit expansion can no longer be relied on to plug a demand leakage. Instead there is a powerful desire to save which is likely to last until private sector debt are at sustainable levels.
3. From the government sector. Demand leakages can be filled by deficit spending. This is when the government sector spends more into the the economy than it extract through taxes. Spending injects demand and taxation subtracts it. That is why tax cuts are a powerful economic stimulus.
Unless countries are net exporters, like Germany, deficit spending is required just to maintain economic activity at a steady state (i.e. no growth). In the absence of net exports the level of deficit spending needs to match the level of net private savings (savings - investment) just to prevent the economy from shrinking. If a country is net importer the budget deficit needs to equal net imports plus net private sector savings just to prevent a recession.
This is another illustration of how deficit spending is usually essential in an economy, since most economies have demand leakages as the private sector tries to save.
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