I Was Wrong: There Is a Substitute for Investment (Investment)

January 17th, 2011

In a recent post I pointed out that taxing financial investments doesn’t discourage financial investment, because there is no substitute for financial investment. If you have money, you either put it in financial investments or your put it in your mattress and watch if dwindle with inflation.

But I was wrong: the substitute for investment is . . . investment.

Allow me to explain two key terms that people — even economists — regularly misuse or use so vaguely as to be meaningless or misrepresentative (mea culpa): “investment” and “capital.” There are two (main) meanings for each.

Investments (these are flows)

1. Productive investments: Known in the National Income and Product Accounts (NIPAs) — the whole pyramid of data underlying GDP — as “fixed investment,” and sometimes called “investment spending” — purchases of assets that are used to produce goods and services (including places to live — “residential fixed investment”*). These assets include structures, hardware (a.k.a. “equipment”), and software. (This should also include knowledge and skills purchased through education and training, but that isn’t included in “fixed investment” in the NIPAs.) I like to call these “productive investments.”

2. Financial “investments”: or more accurately, “savings.” This vernacular usage is what causes the confusion. It so happens that almost all of those savings are stored in financial instruments (“investments”), cause there’s nowhere else to store them. They sure feel like “investments” to those who make them, but they don’t produce anything we can eat or touch or read or ride (or ask to repair the lathe or program the alarm system).

Capital (these are stores, stocks, holdings, or balances)

1. Fixed capital: a.k.a. “the fixed capital base” or “fixed capital stock.” The amount of productive stuff we have — structures, hardware, and software (and knowledge/skills). Fixed investment adds to this stock (or replaces the stock that’s no longer useful).

2. Financial “capital”: a.k.a “money.”** Again, this vernacular usage causes the confusion. Our “financial capital” is, roughly speaking, the total amount of money we have — most of it stored in financial instruments. Savings adds to this stock; fixed investments (and consumption spending) are drawn from it.

So if you have a pile of money, you have four alternatives:

1. Store it in your mattress (or the basic equivalent: a low- or no-interest FDIC-insured bank account).

2. Store it in financial “investments.”

3. Spend it on/invest it in fixed capital — either business capital that generates/increases production of goods and services, or in residential capital that provides places to live.

4. Spend it on current consumption — not a substitute for either kind of investment, because it doesn’t 1. store your money for the future or 2. deliver income/returns on your money.

Key takeaway: Investing in fixed capital –“investment spending” — reduces savings, hence the stock of financial capital (just as consumption spending does). And vice versa: given a certain amount of income and consumption, more savings and financial capital means less investment spending and fixed capital.

When somebody tells you that cutting taxes on the rich increases “investment” or “builds the capital base,” in my experience there’s a good chance they don’t know — or at least aren’t saying — which “investment” or “capital” they’re talking about.

More anon.

* Note that buying a house is not investment in fixed capital; it’s an asset swap. Just like a purchase or sale of a financial security, it has no (direct) effect on GDP. (Though associated commissions and fees do.) Building or remodeling a house is investment in fixed capital, and contributes to GDP.

** People have been arguing for centuries about what “money” means. I won’t enter that fray. I’ll simply say that compared to fixed investments, financial “investments” are very liquid; the great majority can be turned into money/”cash,” even currency, fairly quickly or immediately. That money can be spent on consumption, or invested in fixed capital. (Or be stored in a mattress.)

  1. No comments yet.
Comments are closed.