To take advantage of specialization and economies of scale, firms must build large production facilities that can cost hundreds of millions of dollars. The firms that build these plants raise some funds with new issues of stock, as described above. But firms also borrow huge sums of money every year to undertake these capital investments. When they do that, they compete with government agencies that are borrowing money to finance construction projects and other public spending programs, and with households that are borrowing money to finance the purchase of housing, automobiles, and other goods and services.
Savings play an important role in the lending process. For any of this borrowing to take place, banks and other lenders must have funds to lend out. They obtain these funds from people or organizations that are willing to deposit money in accounts at the bank, including savings accounts. If everyone spent all of the income they earned each year, there would be no funds available for banks to lend out.
Among the three major sectors of the U.S. economy—households, businesses,
and government—only households are net savers. In other words, households
save more money than they borrow. Conversely, businesses and government
are net borrowers. A few businesses may save more than they invest in
business ventures. However, overall, businesses in the United States,
like businesses in virtually all countries, invest far more than they
save. Many companies borrow funds to finance their investments. And while
some local and state governments occasionally run budget surpluses,
overall the government sector is also a large net borrower in the U.S.
economy. The government borrows money by issuing various forms of bonds.
Like corporate bonds, government bonds are contractual obligations to
repay what is borrowed, plus some specified rate of interest, at a
specified time.
Matching Borrowers and Lenders in Financial Markets
Households save money for several reasons: to provide a cushion against bad times, as when wage earners or others in the household become sick, injured, or disabled; to pay for large expenditures such as houses, cars, and vacations; to set aside money for retirement; or to invest. Banks and other financial institutions compete for households’ savings deposits by paying interest to the savers. Then banks lend those funds out to borrowers at a higher rate of interest than they pay to savers. The difference between the interest rates charged to borrowers and paid to savers is the main way that banks earn profits.
Of course banks must also be careful to lend the money to people and
firms that are creditworthy—meaning they will be able to repay the loans.
The creditworthiness of the borrower is one reason why some kinds of
loans have higher rates of interest than others do. Short-term loans made
to people or businesses with a long history of stable income and
employment, and who have assets that can be pledged as collateral that
will become the bank’s property if a loan is not repaid, will receive the
lowest interest rates. For example, well-established firms such as AT&T
often pay what is called the bank’s prime rate—the lowest available rate
for business loans—when they borrow money. New, start-up companies pay
higher rates because there is a greater risk they will default on the
loan or even go out of business.
Other kinds of loans also have greater risks of default, so banks and
other lenders charge different rates of interest. Mortgage loans are
backed by the collateral of the property the loan was used to purchase.
If someone does not pay his or her mortgage, the bank has the right to
sell the property that was pledged as collateral and to collect the
proceeds as payment for what it is owed. That means the bank’s risks are
lower, so interest rates on these loans are typically lower, too. The
money that is loaned to people who do not pay off the balances on their
credit cards every month represents a greater risk to banks, because no
collateral is provided. Because the bank does not hold any title to the
consumer’s property for these loans, it charges a higher interest rate
than it charges on mortgages. The higher rate allows the bank to collect
enough money overall so that it can cover its losses when some of these
riskier loans are not repaid.
If a bank makes too many loans that are not repaid, it will go out of
business. The effects of bank failures on depositors and the overall
economy can be very severe, especially if many banks fail at the same
time and the deposits are not insured. In the United States, the most
famous example of this kind of financial disaster occurred during the
Great Depression of the 1930s, when a large number of banks failed. Many
other businesses also closed and many people lost both their jobs and
savings.
Bank failures are fairly rare events in the U.S. economy. Banks do not
want to lose money or go out of business, and they try to avoid making
loans to individuals and businesses who will be unable to repay them. In
addition, a number of safeguards protect U.S. financial institutions and
their customers against failures. The Federal Deposit Insurance
Corporation (FDIC) insures most bank and savings and loan deposits up to
$100,000. Government examiners conduct regular inspections of banks and
other financial institutions to try to ensure that these firms are
operating safely and responsibly.
U.S. Household Savings Rate
A broader issue for the U.S. economy at the end of the 20th century is the low household savings rate in this country, compared to that of many other industrialized nations. People who live in the United States save less of their annual income than people who live in many other industrialized market economies, including Japan, Germany, and Italy.
There is considerable debate about why the U.S. savings rate is low, and several factors are often discussed. U.S. citizens may simply choose to enjoy more of their income in the form of current consumption than people in nations where living standards have historically been lower. But other considerations may also be important. There are significant differences among nations in how savings, dividends, investment income, housing expenditures, and retirement programs are taxed and financed. These differences may lead to different decisions about saving.
For example, many other nations do not tax interest on savings accounts as much as they do other forms of income, and some countries do not tax at least part of the income people earn on savings accounts at all. In the United States, such favorable tax treatment does not apply to regular savings accounts. The government does offer more limited advantages on special retirement accounts, but such accounts have many restrictions on how much people can deposit or withdraw before retirement without facing tax penalties.
In addition, U.S. consumers can deduct from their taxes the interest they pay on mortgages for the homes they live in. That encourages people to spend more on housing than they otherwise would. As a result, some funds that would otherwise be saved are, instead, put into housing.
Another factor that has a direct effect on the U.S. savings rate is the
Social Security system, the government program that provides some
retirement income to most older people. The money that workers pay into
the Social Security system does not go into individual savings accounts
for those workers. Instead, it is used to make Social Security payments
to current retirees. No savings are created under this system unless it
happens that the total amount being paid into the system is greater than
the current payments to retirees. Even when that has happened in the
past, the federal government often used the surplus to pay for some of
its other expenditures. Individuals are also likely to save less for
their own retirement because they expect to receive Social Security
benefits when they retire.
The low U.S. savings rate has two significant consequences. First, with
fewer dollars available as savings to banks and other financial
institutions, interest rates are higher for both savers and borrowers
than they would otherwise be. That makes it more costly to finance
investment in factories, equipment, and other goods, which slows growth
in national output and income levels. Second, the higher U.S. interest
rates attract funds from savers and investors in other nations. As we
will see below, such foreign investments can have several effects on the
U.S. economy.
Borrowing from Foreign Savers
The flow of funds from other nations enables U.S. firms to finance more
investments in capital goods, but it also creates concerns. For example,
in order for foreigners to invest in U.S. savings accounts and U.S.
government or corporate bonds, they must have dollars. As they demand
dollars for these investments, the price of the dollar in terms of other
nations’ currencies rises. When the price of the dollar is rising, people
in other countries who want to buy U.S. exports will have to pay more for
them. That means they will buy fewer goods and services produced in the
United States, which will hurt U.S. export industries. This happened in
the early 1980s, when U.S. companies such as Caterpillar, which makes
large engines and industrial equipment, saw the sales of their products
to their international customers plummet. The higher value of the dollar
also makes it cheaper for U.S. citizens to import products from other
nations. Imports will rise, leading to a larger deficit (or smaller
surplus) in the U.S. balance of trade, the amount of exports compared to
imports.
Foreign investment has other effects on the U.S. economy. Eventually the
money borrowed must be repaid. How those repayments will affect the U.S.
economy will depend on how the borrowed money is invested. If the money
borrowed from foreign individuals and companies is put into capital
projects that increase levels of output and income in the United States,
repayments can be made without any decrease in U.S. living standards.
Otherwise, U.S. living standards will decline as goods and services are
sent overseas to repay the loans. The concern is that instead of using
foreign funds for additional investments in capital goods, today these
funds are simply making it possible for U.S. consumers and government
agencies to spend more on consumption goods and social services, which
will not increase output and living standards.
In the early history of the United States, many U.S. capital projects
were financed by people in Britain, France, and other nations that were
then the wealthiest countries in the world. These loans helped the
fledgling U.S. economy to grow and were paid off without lowering the
U.S. standard of living. It is not clear that current U.S. borrowing from
foreign nations will turn out as well and will be used to invest in
capital projects, now that the United States, with the largest and
wealthiest economy in the world, faces a low national savings rate.
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