3. Savings and unavoidable Ponzi Dynamics
Many economists treat money as if it were simply an intermediary in the exchange of goods and services, a store of value or something to replace the clumsy mechanism of barter. This book takes a different approach. It acknowledges that money itself can be a badly behaved, strange beast that can and does change its value or requires market-distorting government interventions to control. We will show how the use of money induces behaviours that simply would not occur in a barter world. In this book we shall consider economic phenomena, buying, selling, savings, loans etc., in these two steps:
Work out what the flow of goods and services would be without money.
Attempt to add in money, watching out for money being required to change its value in order for Step 1 to work.
Any behaviour that only occurs with the use of money, i.e. is absent in the world of barter, shall be deemed a monetary phenomenon. In doing this, we hope to show that monetary phenomena are a) very strong, b) affect almost every aspect of economics and c) if ignored, will lead economists and politicians to make some very bad decisions. We shall begin our journey with a closer look at savings.
The nature of savings
This chapter will consider the nature of savings, how their behaviour is rather different from what the textbooks would have you believe. In order to understand savings properly we need to clarify a few new terms and definitions which are different from how savings are normally discussed. First of all we will define three phases of the savings process: set-up and prediction, monitoring and cashing in. Then we shall consider the different types of savings: simple warehouse, concentrated value and contract. These definitions will help us consider the ways in which the value of your savings at the end of the process (when you come to “consume” them) can be much higher or lower than predicted at the start. We will show how savings are prone to something known as Ponzi dynamics. Finally we shall consider whether savings really have to be this way or whether the economy could be configured to be more stable and predictable.
Storing value?
People rarely stop to think about what is really happening when we save. We just assume that we’re “storing value”, metaphorically as if we had a big warehouse of goods that we put things in ready to be consumed at a later date. There are many misconceptions about savings that we need to address in order to have a better understanding of economics. But in order to appreciate these misconceptions we need to be a little pedantic for a moment and consider precisely what savings really are.
Say that you are fit, well and productive right now and could, if you wanted, live comfortably enough consuming less than you produce. You may want to somehow use this spare capacity to arrange that in the future you can get by in a situation where you are producing less than you consume. There are many possible reasons for this desire:
saving for your retirement
saving so that you can support yourself during some period of retraining for a new career
saving just in case something bad happens, like losing your job and having to survive through a temporary period of unemployment.
We can now state that:
Savings are the mechanism by which you attempt to translate a period of producing more than you consume during one part in your life into a supply of goods and services at a later time.
The word “attempt” in the definition is quite deliberate and must not be left out because there are a multitude of things that can go wrong in the process, some obvious and some rather subtle and deceptive.
In many economics textbooks savings and investments are treated quite differently. Savings are described as a kind of passive, non-speculative activity in which you simply “store” value. Investments, however, are seen as a more exciting activity in which you aim to get out more than you put in; you carefully select some business project to invest in. If the business succeeds you may multiply your investment. If the business fails you may lose everything. Clearly savings and investments have some different characteristics, but you may notice the definition of savings just given encapsulates both and this chapter will consider both as simply different flavours of “saving”.
There is a general feeling, certainly among the public, that when you save you almost invariably get out more than you put in, or at the very worst, about the same as what you put in. The only way you can lose out is if you speculated on something risky. You chose the wrong thing. You were the fool that made a mistake while the bulk of everyone else did better. The possibility that the bulk of a population’s savings could fail all at once is scarcely considered as something within the realms of possibility. Most economics textbooks will gloss over this possibility in their discussions of savings. Mass savings failures seem to be a kind of specialist subject, only to be considered by a small percentage of professional economists that study those intermittent economic catastrophes. The bulk of economics students will graduate with the impression that savings are a safe and reliable thing.
Some books describe savings in terms of preferences... you may “prefer” to consume your stuff now or may prefer to consume at a later date. It seems almost as if you are in a shop choosing which kind of cake you want. There is little clue in the language used that you may in fact be choosing between one kind of cake and a 50% chance of getting the other kind.
In this chapter we hope to show that there is no such thing as a safe type of savings. All savings have the potential to fail to some degree or other, even ones that get erroneously defined as 100% safe in the textbooks, like government bonds.
Before we can go on to discuss these failure mechanisms we need to establish some more concepts and terminology. First of all we need to consider the different stages of the savings process and then the different types of saving mechanism.
There are many types of savings, but whichever one is used we can identify three stages in the process:
Set up and prediction. The “set up” part is the point at which savings are instigated. We put money in the bank, we buy some bonds, we invest in some shares etc. The “prediction” is our estimate of what we will be able to get in terms of goods and services at that future point in time where we intend to “consume” our savings. Our enthusiasm for saving and our decisions about how much to save are likely to be influenced by our prediction.
Monitoring. Very often it will be possible to monitor the progress of the value of our savings. These rises and falls may influence our decisions about whether or not to make more or less additional savings.
Consumption or cashing in. This is that point at a future time, when we decide to, or need to, consume more than we produce. We now need to convert or “cash in” some or all of our savings to translate into goods and services.
So now we are ready to introduce the different types of saving and for each one we will consider its practicality, predictability and stability.
Savings type 1: Simple warehouse
The crudest form of saving, we will call simple warehouse. This is where you quite literally build up a store of the things you will need in case of a rainy day. For this type of savings you will need storage space. If you need to save for a sustained period, the space will need to be quite large, perhaps a warehouse. You will have to either rent or buy this warehouse and maintain it. You may also need to hire a security guard to make sure nothing gets stolen. All the food you store will have to be tinned or frozen. If it’s frozen you will have to pay for the electricity to run the freezer. If you store things over a very long period you may find that some items gradually become redundant. That collection of floppy discs and VHS cassettes and that record player may all be pretty useless by the time you reach a point when you need to get by on, or consume, your savings. Finally you will notice that services, like medical care or hairdressing, cannot be saved via this mechanism at all.
At this point you will hopefully be getting the idea that the warehouse savings method is riddled with problems and nobody in their right minds would even attempt to save in this way over a sustained period in our modern society. We can summarise this as follows:
Warehouse savings are highly problematic and don’t work for services at all.
Needless to say this savings mechanism is scarcely used in the real world today.
Savings type 2: Concentrated value storage
Anyone looking at a description of the simple warehouse mechanism may be thinking to themselves, “Don’t be silly – you shouldn’t attempt to save the full range of things that you use every day!” The obvious fix to this stupidity is the following: When you want to save, trade in your produce for something that has high value in a compact and durable form, perhaps gold or diamonds. This can be stored far more cheaply. At a later time, when you need to live off your savings, you just trade your gold/diamonds back into the full spectrum of goods and services you need. We will label this mechanism concentrated value storage.
At first glance this mechanism appears to solve just about all the problems associated with the simple warehouse method. The costs of storage will be relatively low and you can have complete flexibility as to exactly what goods you can get in the future as well as the option to get services.
This type of savings appears to be very safe and pedestrian. Surely there is no risk involved, is there? Surely we just get out the same as we put in and there’s nothing else to it. Unfortunately not. This type of savings can perform well or badly for reasons rarely discussed in the textbooks. We shall illustrate how with a series of three thought experiments. In the first experiment we will present a simple scenario in which the savings perform well. Then, as we add more realism, we will begin to see instability creep in.
Thought experiment 1: Very few people saving
Let us imagine an island where there are only two types of good, namely potatoes and jewels. These choices are actually surrogates for essential, perishable goods and non-essential, non-perishable goods. There is no money, no banks, only barter. The potatoes grow year round and in living memory the harvests have never failed. For the sake of simplicity, let’s assume that all the jewels in the world are of similar size and quality, as are potatoes. Let’s also state that all the jewels in the land, that could ever be found, have already been found. There are no more mines or other sources, so the total quantity of jewels is fixed.
Some islanders like to have jewels to wear and show off their status at social events. Jewels are relatively rare and so when trading they may command an exchange rate of, say, 100 potatoes each. Everyone on this island has ample land and they make their own huts from the plentiful wood and leaves. There is very little demand for any savings on this island because old people get looked after by their children so there is no need to save up in any way for old age. In this scenario we would expect the exchange rate between jewels and potatoes to be dominated by their scarcity and value purely as fashion items.
In this scenario imagine that you are a bit of a worrier; perhaps you have no family and few friends and are worried that you may get ill at some point and not have the energy to forage for potatoes. Having some savings will help you get through that potential hard time ahead. Imagine also that very few others have such concerns, so few others simultaneously want to save. In order to “save”, you would now trade some of your excess potatoes for jewels at the going rate. Let’s say this is around 100 to 1. Then at a future time, when you needed to live off your savings, you could trade in your jewels for potatoes at approximately the same rate. Your savings have been 100% efficient.
To summarise:
In a scenario where very few people save, the value of jewels will be predominantly a function of their desirability as fashion accessories. Any rare person who does choose to use jewels as a “savings conduit” will find their savings to be perfectly efficient.
Thought experiment 2: Lots of people saving (steady state assumption)
In this variation, you are not the only one wanting to save. Lots of people want to save for the future for one reason or another. Perhaps it is not the tradition for the elderly to be looked after by their children. Under these conditions there would be a strong desire for retirement savings. Jewels would now generally be seen as dual purpose, both a fashion item and a savings conduit.
So now let’s consider what the exchange rate between jewels and potatoes might be compared to the case where very few people saved. In the world without much savings, consider the pool of people who may be tempted to buy jewels. Clearly not everyone has that desire equally. Jewels are non-essential, a matter of taste. Some people may have no interest in them at all while others may crave them. Among the population there will be a certain distribution of desire for jewels. This is shown as a Venn diagram below:
Now consider a situation in which there is a great desire for savings and jewels are now dual purpose. The desire for jewels as a fashion item will not have diminished, but now there will be a new, additional distribution of desires for jewels as a savings conduit. There will be some people who had no desire for jewels as a fashion accessory but do have a desire for jewels for savings. This new combined collection of desires will be greater than the original and consequently the price will be higher, i.e. the exchange rate with potatoes will be raised. Let’s say that it could be perhaps 200 potatoes per jewel. This new desire for jewels is illustrated below:
In this thought experiment we are assuming, that the rate of new people starting to save is in constant balance with the rate of previous savers now starting to live off their savings. The potato/jewel exchange rate will be steady.
It should be noted that under these circumstances it is easy for savers to predict the final value of their savings and their savings will all be efficient. People will get out approximately the same as what they put in.
To summarise:
In a scenario where there is a large but stable desire for saving, the value of jewels will be partly a function of their desirability as fashion accessories and partly a function of their desirability as savings conduits. Anyone who uses jewels as a “savings conduit” will find their savings to be perfectly efficient and predictable.
Thought experiment 3: Lots of people saving (more realistic assumptions)
So far the thought experiments have resulted in scenarios where savings are very well behaved, predictable and efficient. This is all about to change.
Let’s consider what happens if the desire for savings within the society is not constant. This could occur for a wide variety of reasons in the real world:
demographics, e.g. immigration, emigration, lifespan changes, changes in the average number of children per family
tax changes
regulatory changes
changes in social norms, e.g. changes in the propensity for children to look after their parents in old age
optimism/pessimism about future wealth/job security.
It is important to note that there is a wide variety of timescales over which these changes can occur. Some, like regulatory changes, may happen overnight, while others, like changes to the average number of children per family, may play out over decades. The result of any of these changes is that the balance between the numbers of new people wanting to start saving and previous savers wanting to start living off their savings, will no longer be steady and subsequently the exchange rate between jewels and potatoes will no longer be steady. We can approximately sum up the expected jewel/potato exchange rate in the following table:
New people wanting to save greater than existing savers wanting to cash in
Upward pressure on the price of jewels
Existing savers wanting to cash in greater than new people wanting to start saving
Downward pressure on the price of jewels
Changes in the jewel/potato exchange rate over time are illustrated in Figure 5-6.
If in general there was little need for savings, i.e. the circle on the right-hand side of the previous Venn diagram in was far smaller than the one on the left, then the price of jewels would be dominated by their desirability as fashion accessories. The area of the circle on the right could double or halve without having much effect on the selling price. If, however, things were the other way round, i.e. the circle on the right was far larger than the one on the left, then the price of jewels would be dominated by the demand for savings. Now that same doubling or halving of the desire for savings would have an enormous effect on the price of jewels. We can sum up the situation as follows:
The greater the need for savings in society, the more variable the price of commodities used as savings conduits will be.
A generally high demand for savings by society as a whole makes it much harder to predict how much you will get out at the other end when you start saving.
Let’s now consider who is buying and selling the jewels at any one time and their motivations:
Buyers
(people whose actions push the price up)
Sellers
(people whose actions push the price down)
Relatively stable part
Group A: People wanting to buy jewels predominantly as fashion items
Group B: People who had previously owned jewels as fashion items deciding they want to sell
Unstable part
Group C: New savers wanting to buy jewels as savings conduits
Group D: Ex-savers wanting to cash in
If Groups C and D are large and dominate jewel trading then the price can said to be being “kept up” by C. The value that Group D can get when they cash in, will be predominantly determined by the process of selling their jewels to Group C. If C shrank relative to D, then the price would fall.
This mechanism can now be seen to have what has been referred to as Ponzi dynamics.
Charles Ponzi 1882–1949
Charles Ponzi was an Italian swindler. The gist of his scam was an “investment scheme”. People would invest their money in return for a very high rate of return. Little did the investors know that the money they were able to take out from the scheme was made up mostly from the money of new investors joining the scheme rather than from any skillful investing. This could only continue so long as there was an ever-increasing supply of new investors. Clearly this state could not continue indefinitely, and sure enough in 1920 the scheme collapsed and Charles Ponzi was sent to prison.
Bernard Madoff operated a scam on the same basis and was caught out in 2008.
Normally people consider Ponzi schemes as something illegal, occasionally attempted by a rogue criminal. But Ponzi dynamics in savings cannot be avoided; they are “baked in”. They are a natural consequence of the variability of savings desires.
So we now see that the efficiency of savings will vary depending on the balance between ex-savers cashing-in and new savers starting to save. This appears to be a nuisance, an irritation, an effect that leads to variations in savings efficiency that we hope is not too large. Sadly, there is worse to come. There are feedback mechanisms at play. The problem is that the changes in the jewel / potato exchange rate brought about by changes in the balance between new savers and ex-savers, in and of itself, serves to affect the imbalance. In order to explore the nature of the feedback, let’s imagine for minute that the price of the jewels had been rising steadily for a sustained period, for some reason. Consider the reaction to this scenario by some different groups within society:
Group
Reaction to sustained rise in price of savings conduit
“I currently have few or no savings but it is essential that I start to save for my pension. I need X amount of goods and services in my old age.”
“Savings values appear to grow so well that I only need put away a small amount for the future.” This person may be fooled into putting in too little for their pension.
“It is optional that I save in the short to medium term. I may be tempted to save if my prediction of the cash-in value is substantially more then what I put in. I may attempt to use this growth in savings value as a form of ongoing income.”
Encouraged to save.
“I already have some savings. I am in stage 2 of the savings process, the monitoring phase.”
“Wow, my savings are doing so well. I’m going to be very comfortable in my old age. I certainly don’t need to add to my savings. Indeed I could even cash in some of my savings early, consume them and still have enough for the future.”
It is hard to say exactly which way this feedback will end up, positive or negative, because the rising price of jewels will affect different groups in different ways. Also, at any one time there may be different proportions of people in the different situations, some encouraged to save more, others encouraged to save less. One thing you can say for certain is that if people are unaware of the Ponzi dynamics at play and they assume that the price changes are based on purely non-Ponzi reasons, then they are liable to make mistakes in both the prediction and monitoring phases of their savings plans. This will cause there to be periods in which there is a tendency for people save more than they really intended and other periods where people will save less than they intended.
Sadly when you go and see a pensions advisor to ask how much you need to put aside each month in order to have a decent pension, it is unlikely they will warn you of Ponzi dynamics at play.
Savings type 3: Contract savings
So now we come on to the next form of savings which we will call contract saving. This is where you find someone who is keen to get hold of your excess production now in return for an agreement that they will “repay” you with goods or services at some point in the future. There is no need for the goods used for repayment to even be in existence at the time that the agreement is made.
The wording of the contract can take a very wide variety of forms, for example:
“I’ll give you one fridge, a Hoover and a washing machine in return for you giving me a television, an iPod and a games console at some time in the future.”
or
“I’ll give you one month’s worth of whatever I produce in my workplace now, then you give me one month’s worth of whatever you produce in your workplace at some time in the future.”
But the real advantage over warehouse and concentrated value savings can be seen in the following example contract:
“I’ll give you a collection of goods and services now to enable you to build a new factory and start a business. If the business is profitable then at some time in the future you give me a collection of goods and services taken from the profits of that company. I expect this to be much larger than the collection I gave you in the first place to compensate me for the risk that the business will fail.”
This specific form of contract could be labelled an investment contract. It is this form of contract that lies at the heart of capitalism. Out of all the savings mechanisms seen so far, this one appears to have hit the jackpot. Not only can we translate our superfluous goods and services now into the future, but we have a mechanism for getting more in the future than we put in. Not that this can’t happen with concentrated value savings, but with this form of contract savings we can see an explicit mechanism for growing the value of our savings conduit.
A real-world example of this kind of contract would be purchasing a share in a company in the primary market, holding on to the share and collecting dividend payments. Note that purchasing shares on the secondary market was not used as an example, for reasons that will be discussed later.
Contract savings need a willing partner
There is a fundamental difference between contract savings and either simple warehouse or concentrated value savings. Contract savings need a willing party on the other side of the deal. The person on the other side of the contract must have a desire to do the opposite of saving. They must be keen to borrow. Borrowing is the consumption of goods and services now in return for an obligation to pay back goods and services in the future. In a steady state equilibrium there would be equal enthusiasm for borrowing and saving. Everyone keen to do some saving would be able to find a corresponding person keen to do some borrowing. But as we have already seen, there are many reasons for saving/borrowing enthusiasm to get out of balance. When the balance is unequal then one side will be able to drive a harder bargain. This can be summed up in the following table:
Bias
Typical deal struck
Excess of savers over borrowers
“I’ll give you a large amount of goods and services now in return for a small amount of goods and services in the future.”
Excess of borrowers over savers
“I’ll give you a small amount of goods and services now in return for a large amount of goods and services in the future.”
Money acts as a form of contract savings
If your job is to make a product or offer a service then when you exchange your good or service for money, the dollar bills are a kind of contract with the rest of society. The dollar bills could be considered to be a contract saying: “In return for those goods or services you just gave to one particular individual within our society, we will give you some goods or services of your choice at a time in the future of your choosing to be collected from any member of society.”
To make this clearer, we can illustrate this with the following two diagrams. First of all there is the savings set-up stage, where you may exchange your goods or services that you produce to Man A, who of course is part of society, in return for a contract, i.e. dollar bills, promising goods or services in the future.
Now at a later time we arrive at the consumption phase of the savings process. We can consume our savings by swapping the contract, i.e. some dollar bills, for a collection of goods or services to be delivered by Man B, another member of society.
It’s almost as if society is a large company where the management has given every “employee” the authority to arrange contracts with you.
Money on its own, i.e. simply “stored under the mattress”, is normally a rather poor form of savings because governments, in conjunction with the banking system, usually conspire to create ever increasing amounts of it, thereby reducing the amount of goods and services that can be purchased at the consumption stage.
The stability and predictability of contract savings
We have already seen how concentrated value savings can suffer from swings in value due to Ponzi dynamics. In this section we will consider how contract savings compare.
The predictability of contract savings depends very much on the wording of the contract. We shall now consider the characteristics of a variety of forms.
Short name: “DAYS’ WORK SWAP”
Contract type: “I’ll give you X days’ worth of my goods and services now in return for Y days’ worth of whatever you produce in the future.”
Predictability: This simple-sounding arrangement is actually highly predictable for long-term savings. If your plan is to be able to support yourself for a period of length Y in the future, then it is very easy to know how much of this type of arrangement to make.
What could go wrong? The person on the other side of this deal may die or become incapacitated. This risk can be mitigated by making multiple smaller-scale arrangements with a number of different people.
Popularity: Despite the good stability and predictability of this arrangement, not many contracts of this type are drawn up in the real world today.
Short name: “MONEY SWAP”
Contract type: “I’ll give you $X now, so that you can buy some goods or services, in return for $Y in the future.”
Predictability: This type of contract is hard to predict over extended periods in terms of what collection of goods and services could be purchased with $Y. If there is an unexpected, sustained period of high inflation then the value of the savings at the consumption stage could be decimated. Conversely if the set-up stage for this contract was made during a period of high inflation then the person on the other end of the contract may set their value of Y accordingly high. If inflation then unexpectedly drops or even becomes negative (it can happen) then that person may struggle to be able to get $Y together at the end of the contract and may be forced to default.
What could go wrong? Unexpected changes in the rate of inflation, either up or down.
Popularity: Despite the many problems with predictability and the risk of default, this is a very popular form of contract in the real world today.
Short name: “INVESTMENT FOR PROFITS SWAP”
Contract type: “I’ll give you $X now so that you can start a business, in return for Y% of the profits of that business in the future.”
Example: This type of contract corresponds to buying some original shares in a business, then holding on to them and collecting the dividend payments.
Predictability: While there may be great variability in the value that can be extracted, a skilled investor should be able to arrange a bias toward getting more out than was put in. The variability of this form of contract can be reduced markedly by making multiple smaller contracts with a wide variety of businesses. The predictability of this type of contract is essentially one and the same thing as your skill in predicting the profitability of new companies.
What could go wrong? If you are a poor judge of the future profitability of new companies then your savings may lose value.
Popularity: This is done to some degree in the real world today, though it is not nearly as often practised as an alternative, more complicated variation which we come to next.
Short name: “VALUE CHANGE SEQUENCE”
Contract type: A multi-step chain of contracts as follows…
“I’ll give you $A now, for that certificate of ownership of part of that existing business X, which I will then sell a short time later for $B” – followed by…
“I’ll give you $B now, for that certificate of ownership of part of that existing business Y, which I will then sell a short time later for $C” – followed by…
“I’ll give you $C now, for that certificate of ownership of part of that existing business Z, which I will then sell a short time later for $D”
etc. etc.
Example: This corresponds to buying and selling shares on a frequent basis, making money predominantly from changes in the price of the shares rather than from dividend payments.
Predictability: Many economists appear to assume that the value change sequence method of savings is simply a more flexible form of the “investment for profits swap” in the previous table. They assume that all the characteristics with regard to stability and predictability are identical. This assumption could not be more untrue. Unfortunately the precise reasons this assumption is false is complicated, but they will be explained in detail later in the book.
What could go wrong? Many things. We shall discuss these later in the book.
Popularity: This form of savings is enormously popular. The pensions provisions of millions of people are dependent on this mechanism.
As you can see, the popularity of different contract savings mechanisms is rather at odds with their inherent predictability and stability. If we want to design a more stable economic system then this contradiction will need to be addressed.
Saving scenario thought experiments
So now we have considered some properties of the savings process. It will be useful to work through some specific scenarios.
A model of the introduction of pensions
Coming back to the jewel and potato world, let’s say that the society starts out in a state where there is little desire for savings. Traditionally the children look after their parents when they eventually become too old and frail to get food for themselves. This has been the status quo for many generations. Then there is a change in society. For some reason there is a move toward the idea of people saving toward their old age. People are now encouraged to buy jewels as a savings conduit through their working lives so that when they become elderly they can cash in their jewels to get by.
In the early years of this transition, the price of jewels will rise as more and more are purchased as a savings conduit. Note that in this phase there will be very few old people in the cashing-in stage, i.e. there will be very few ex-savers in the process of selling jewels to get by. The savers will be monitoring the progress of the value of the savings in order to judge just how many jewels they will need to buy in their working years. They will observe unusually high and rising prices of jewels. This will naturally lead people to believing that they don’t need to collect many jewels in order to get by. If people are unaware of Ponzi dynamics at play then the high and rising prices may erroneously be attributed to spurious other factors.
A few decades may pass in this “optimistic” state, but then things will start to change. There will be a gradual rise in the number of people becoming old and entering the stage where they need to sell their jewels. More people selling will naturally lead to a lower price. People entering their latter years will now be disappointed to see that the previous estimated value of their savings conduits was too optimistic. There may be too little time left to correct the error and their final years may be spent in poverty. Figure 5-9 illustrates the evolution of the price of jewels in the process.
It is important to realise that should the new “saving for your old age idea” remain in place for generations to come, with a constant population, the jewel price would eventually stabilise at a new level and the number of savings errors would eventually reduce. It is large changes in savings propensity that lead to the errors.
Another feature that may have stood a chance of reducing this type of saving error is simply to ensure that the economics textbooks were teaching students to pay attention to the Ponzi dynamics inherent in most savings mechanisms.
One criticism of this explanation may be to say that with such a simple scenario it may be obvious to everyone what is happening. The participants would never be so stupid. Indeed in the jewel and potato world this may be the case. In the real world however, we have many additional complicating factors like the use of money, fractional reserve banking, international trade and many others. These factors all serve to obfuscate the fundamentals of what is going on under the surface. They also mean that when Ponzi dynamics drive up the price of a commodity, it is virtually certain that there will be other things that economists can point to as explanations. Indeed there can be multiple reasons for price changes all going on at the same time. When this is the case, Ponzi dynamics are usually the last thing on the minds of economists.
A demonstration of how one person saving can work but everyone saving can fail
It is an inherent feature of savings mechanisms that the number of people simultaneously attempting to save can have an impact on the success of those savings. We shall illustrate this with another thought experiment.
Imagine that it has been arranged that 10,000 sterile people (sterile in the sense that, they can not reproduce), who are all 20 years old, are placed on an island that is separated from the rest of the world. Each one is given a sum of money to trade with. When they get to the island each person specialises in making whatever it is that they have the skills to make and they all trade with each other using the money that they were given. Now imagine a particular islander, let’s call him Tom. One day he has a thought: he realises that when he becomes elderly he’s going to be weaker and slow down. He won’t be able to make so much stuff that he can trade for food etc. So he decides to save a certain fraction of his money under the mattress for his old age. Let’s also imagine that Tom is the only person who had this realisation and he didn’t tell anyone else.
Now fast forward a few decades... Tom is now 80 years old, as are all the other islanders. Tom is now in a much better state than the rest of the population. He can use his saved money to buy extra stuff to make sure he can keep his standard of living just as high as it was when he was younger.
Now let’s consider what would happen if everyone was saving…
In this scenario Tom has the same realisation about his old age, but this time he tells everyone else. This time everyone on the island decides to save for their old age. They’re all worried that when they slow down they won’t be able to keep up their standard of living unless they save. Now you can imagine what’s coming...
Fast forward a few decades and now everyone is 80 years old. Everyone has slowed down and is producing less stuff per day. It is easy to see that on average everyone’s standard of living will go down in old age in exactly the same way as if they hadn’t bothered to save at all. Everyone thought they were saving to prop up their future lifestyles – but they were deluding themselves.
Notice that there is the same amount of money throughout the experiment. So when the now elderly population are producing a smaller quantity of goods and services with an unchanged quantity of money in the system, the average cost of those goods will naturally rise. Notice that the purchasing power (value) of money changes in order that an undeniable truth is enforced.
Conclusion
Hopefully at this point you can see that the entire concept of savings is far more unstable than may appear at first glance. The value of savings conduits can go up and down en masse, and this variability can in and of itself cause feedbacks which have the potential to induce further variability, turning some minor variations into larger swings. This variability will inevitably lead to errors in the prediction and or monitoring phases of the savings process.
Prediction errors in savings can have devastating effects. People who had been putting too little away for their retirements for decades because they had been deluded into thinking that their pension pots were growing strongly may unexpectedly find that they have to spend the last years of their lives in poverty. And sadly this is not the end of the story with regard to the instability of savings. In later chapters we shall see how the behaviour of fractional reserve banking can further interfere with the savings process to make the instability and feedback problems even worse.
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