05 Saving, Investment, and the Financial System

Lecture from: 14.10.2025 | Video: Video ETHZ

Context: The Engine of Sustained Growth

The Solow model predicts that without technological progress, growth eventually ceases. This connects directly to the work of Nobel Laureates Joel Mokyr, Philippe Aghion, and Peter Howitt. Their contribution was to endogenize technology, making it an outcome of the economic system rather than an external gift.

They model growth as a process of creative destruction.

Creative Destruction

Coined by Joseph Schumpeter, this describes the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” New innovations (like the steam engine or AI) render old inputs obsolete. Though disruptive, this is the engine of long-run progress.

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Finishing Lecture 4: Unemployment and the Labour Market

Before discussing the financial system, the analysis of unemployment concludes here.

Comparing Unemployment Measures

Two different figures for unemployment are often cited in Switzerland:

Measure	Source	Methodology	Note
Claimant Count (Arbeitslosenquote)	SECO	Counts people registered at regional unemployment offices.	Heavily influenced by social security rules. Lower than ILO rate.
ILO Survey (Erwerbslosenquote)	SFSO	Standardized household survey (international standard). Starts by asking people their status.	Captures non-registered job seekers. Use this for international comparisons.

Duration of Unemployment

A seeming paradox exists in the data:

“Most spells of unemployment are short, but most unemployment observed at any given time is long-term.”

Explanation: Many people lose jobs but find new ones quickly (short spells). However, the few people who remain unemployed for years accumulate in the pool of the unemployed, disproportionately affecting the “snapshot” rate at any given time. Long-term unemployment is particularly damaging due to skill atrophy.

Why Is There Always Some Unemployment?

In a perfectly flexible market, wages would adjust to balance supply and demand ($W_E$), resulting in zero unemployment.

In reality, the market does not always clear. Two types of unemployment explain why the rate remains above zero:

1. Frictional Unemployment

Unemployment resulting from the time it takes to match workers with jobs. In a dynamic economy with sectoral shifts, job search is inevitable.

2. Structural Unemployment

Unemployment resulting because the number of jobs available is insufficient for everyone who wants one at the prevailing wage. The wage is stuck above the equilibrium level.

Causes of Structural Unemployment:

• Minimum-Wage Laws: If set above equilibrium, they create a surplus of labor (unemployment), particularly among low-skilled workers.
• Unions: By bargaining collectively, unions can push wages above equilibrium. This benefits insiders (members) but hurts outsiders (non-members who may lose jobs).
• Efficiency Wages: Firms may voluntarily pay above-market wages to increase productivity.
  • Why? Better worker health, lower turnover, higher quality applicant pool, and increased effort (fear of firing).

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Saving, Investment, and the Financial System

The focus now turns to the institutions that translate saving into productive investment. (Note: The analysis remains in a “real” economy, resources are being traded intertemporally, not just money).

Financial Institutions

The financial system matches one person’s saving with another’s investment. Institutions are grouped into two categories:

1. Financial Markets: Savers provide funds directly to borrowers.
   • Bond Market: Certificates of indebtedness (IOUs).
   • Stock Market: Claims to partial ownership and future profits.
2. Financial Intermediaries: Savers provide funds indirectly.
   • Banks: Take deposits and make loans.
   • Mutual/Pension Funds: Sell shares to the public to buy diversified portfolios.

The Role of Banks: Maturity Transformation

A critical function of banks is maturity transformation: transforming short-term, liquid liabilities (deposits) into long-term, illiquid assets (mortgages, loans).

Systemic Risk

This function creates value but also liquidity risk. A bank cannot sell long-term assets quickly. If all depositors withdraw at once (bank run), the bank collapses. Because confidence is contagious, this creates systemic risk.

Macroprudential Policies to Mitigate Risk:

• Deposit Insurance: Guarantees savings, preventing panic.
• Capital Requirements: Mandates buffers against losses.
• Lender of Last Resort: Central bank provides liquidity during crises.

Case Study: The Great Financial Crisis (2007-2009)

The crisis originated from securitization gone wrong:

1. Origin: Mortgage loans were bundled into pools.
2. Securitization: Special Purpose Vehicles (SPVs) issued CDOs (Collateralized Debt Obligations) backed by these mortgages.
3. Tranching: CDOs were sliced into risk tiers (Senior = Safe, Junior = Risky/High Return).
4. Complexity: Risky tranches were repackaged into new CDOs (“CDO-squared”).

When sub-prime borrowers defaulted, the complex structure collapsed. “Safe” assets became toxic. The interbank market froze as trust evaporated, leading to a massive credit crunch.

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Saving and Investment in National Accounts

The relationship is formalized using the national income identity.

$Y=C+I+G+NX$

For a closed economy ($NX=0$):

$Y-C-G=I$

The left side is National Saving ($S$), total income remaining after consumption and government purchases.

$S=I$

National Saving must equal Investment.

Saving can be decomposed into private and public components by introducing taxes ($T$):

$S=\underset{\text{Private Saving}}{\underbrace{(Y-T-C)}}+\underset{\text{Public Saving}}{\underbrace{(T-G)}}$

• Budget Surplus: If $T>G$, public saving is positive.
• Budget Deficit: If $T<G$, public saving is negative (dissaving).

Crowding Out

When the government runs a deficit ($T<G$), it reduces national saving. This leaves fewer funds available for private investment, a phenomenon known as crowding out.

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Continue here: 06 The Monetary System