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Capital and Savings

When The Wealth of Nations was published in 1776, James Watt and others were making the improvements to the steam engine that would usher in a century of steam power and set the stage for the age of fossil fuels. A technological revolution was underway, but it was still too early to really understand that. What the economists in the generation after Smith did recognize was the importance of machinery, or what economists call capital. The economist who explained the importance of capital best was David Ricardo.

Ricardo developed a complete model of the economy in an effort to figure out how much income different groups would earn. He was a master of abstraction, and he simplified the economy into three types of resources: land (or natural resources), labor (or human resources), and capital (or man-made tools that increase production). This simplification is still used today. Ricardo imagined an economy at rest that for some reason increased the amount of capital. Production would increase, and if population did not increase as a result, per-capita income would rise, which would mean a higher standard of living. You might think that if capital kept growing, then production could grow without limit, but Ricardo saw a limit: diminishing returns. Additional increases in capital would yield smaller and smaller increases in output, until the contribution of more capital would be nil. At this point, no further improvements in the standard of living would be possible.

Ricardo tells a more complicated story than that outlined in the previous paragraph, and you can find out about those complications from many other sources if you are interested. For our purposes, we want to emphasize that additional capital produces additional output and that to get additional capital, investment and savings are necessary. A nation that does not invest, perhaps because it does not save, will have less capital and hence a lower standard of living than a nation that invests more.

In the 1950s the pre-Keynesian growth model was revived in mathematical splendor. Robert Solow of MIT led the revival of what is now called the neo-classical growth model. The Explore supplement to this page allows you to play a bit with some of the results of this model.

Since Ricardo, economists have stressed the importance of capital. Sometimes they have overstressed it, as in the 1950s when they worried that the Soviet Union would grow faster than the United States because it seemed to be investing more. However, they have also expanded their understanding of capital beyond factories and physical machines. They now recognize that the development of skills that make people more productive is a form of capital and they call these skills human capital. The two most important ways of building human capital are by education and on-the-job training. Today when economists talk about economic development, human capital is likely to be as important as physical capital.

Concern about investment has made economists aware of the importance of financial markets and financial institutions in growth and development. Those who save are generally different people than those who invest. If a society cannot bring together these two groups so they can cooperate in mutually beneficial exchange, it will struggle to grow. An effective financial sector requires well-defined property rights and a judicial system that enforces contracts. Without enforceable contracts, the risk of lending is so high that little will take place.

Finally, we see the importance of savings and capital emphasized in what some, such as Jeffrey Sachs, term the "poverty trap."1 They argue that there are some nations that are so poor that they cannot save. Because they cannot save, they cannot invest and increase capital. Hence, they are trapped in poverty. The solution is for outsiders to provide aid so that they can make the initial investment that will get them onto the ladder of development. To use an analogy, consider a poor fisherman who must fish all his working hours to feed himself. If he could take time to make a net, he could be able to catch more, but if he does take this time, he will starve. However, if someone gives him assistance, he can then make the net, produce more fish, and have free time to plot other ways to increase his wellbeing. The savings could come from foreign investment, but Sachs downplays this source, emphasizing the need for government foreign assistance. He emphasizes the need for investment in education, health, and infrastructure.

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1 Jeffrey Sachs, The End of Poverty: Economic Possibilities for Our Time. Penguin, 2006. William Easterly in The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good (Penguin Press, 2006) dismisses the notion of the poverty trap. He says that there are no nations in a real poverty trap. He also is more pessimistic than Sachs about the ability of poor-nation governments to spend aid wisely.

Copyright Robert Schenk