Loans create deposits, not savings
Investments are necessarily constrained by savings
10 July 2019
According to our
India’s investments, and thus, sustainable higher growth, is constrained by the sharp decline in
the gross domestic savings (GDS) led by the household sector. While related arguments are gaining traction in the
mainstream, several pseudo theories have come forward, two of which are gaining momentum. However, with some
basic analysis, these two related pseudo theories can be proved invalid.
Pseudo theory#1 – Loans create deposits, and thus boost savings:
According to this theory, low deposit growth, and thus,
lower savings can be addressed if lenders are able to lend freely. Since all loans automatically lead to deposits, more
credit will address the issue of low savings.
Pseudo theory#2 – Low savings can be addressed by pushing investments higher:
It is also argued that the key to revive
savings in the economy is by pushing investments higher. Since savings and investments move in line with each other,
higher investments will boost savings, and thus, the policymakers should focus on the former than the latter.
Both these theories start with undeniable facts – a tautology, in fact – but end up with grossly incorrect conclusions. In
this note, we prove that while loans create deposits, they don’t impact savings at all. Money creation (via
credit/deposits) must not be confused with loanable funds (savings/investments) theory.
Further, historical evidences prove that while investments and savings move together, as our
“Theory of Everything”
suggests, a pick-up in investments has always outpaced the pick-up in savings. This leads to higher current account deficit
(CAD), and thus, makes the revival in investments unsustainable. Investments, therefore, are necessarily constrained by
savings. And it is always desirable if the revival in savings precedes the investments recovery.
For the past few years, we have
that India’s current model of consumption-
driven growth is highly unsustainable and must be replaced by investment-led
recovery. In order to make a successful transition from consumption to investments,
India’s savings must first rise because a revival in investments without sufficient
savings will create external imbalances. As our thesis is making inroads in the
mainstream, several other pseudo theories have appeared with arguments in total
contrast to our thesis. In this note, we discuss two such related pseudo theories,
which are highly misleading and can be easily proved incorrect after some
Theory#1: Loans create deposits, but don’t affect savings
Although higher credit leads
to deposits, it does not
affect savings at all
The first theory argues that low deposit growth could be addressed by pushing
credit higher. After all, when lenders loan out money to a borrower, it instantly
creates deposits. Thus, loans create deposits, and since deposits are counted as
savings, higher deposits should lead to higher savings. Notwithstanding the
massively incorrect conclusion, the simplicity of the theory has definitely gained
some ground. The proponents of this theory, however, are massively confused
between the theory of money creation and the theory of loanable funds. Although
higher credit leads to deposits, it does not affect savings at all. There are only three
borrowers in an economy – household (or individual), a corporate and/or the
government. Let us consider an example and understand why higher
lending/borrowings don’t affect savings.
Nikhil Gupta – Research Analyst
(Nikhil.Gupta@MotilalOswal.com); +91 22 6129 1555
– Research Analyst
(Yaswi.Agarwal@motilaloswal.com); +91 22 7193 4196
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