Are Borrowing and Saving Complements or Substitutes?

In developed economies, households often use both savings and borrowings to produce large amounts of capital to buy fixed assets like houses and vehicles. House buyers, for example, make a down-payment from their savings and borrow the rest. Saving and borrowing are thus complements in this context.  

Behavioral economics provides another mechanism through which saving and borrowing act as complements: for households that are loathe to draw down their hard-earned savings, the ability to borrow–and thus to leave their stash of savings untouched—can function as a helpful way to maintain accumulations. Were households more confident in themselves, or if they had better mechanisms to achieve discipline, “borrowing to save” would be less useful, but in an imperfect world it can be the best of an array of imperfect strategies (Morduch 2010). 

In other contexts, borrowing and saving are depicted as alternative activities.  In making intertemporal choices, consumers eager to consume today will draw down savings or borrow; consumers focused on consuming at later dates will instead save. This rock of neoclassical theory takes as given that consumers are wage earners, not entrepreneurs (more precisely it takes as given that income is exogenous). For entrepreneurs (like small-scale microcredit borrowers), income is instead endogenous, and they routinely seek to borrow in order to generate income for the future. In this case, borrowing is a forward-looking household activity, not one driven by immediate consumption needs. As Bauer et al (2011) find, it is the more patient villagers in their sample who are most likely to borrow, even more so than their impatient neighbors.

Bauer et al (2011) draw a second connection between loans and saving, arguing that microcredit borrowing can compensate for the lack of disciplined ways to save. Working in villages in Karnataka, India, we suggest that if consumers had better ways to save, they would. But, until then, the microcredit borrowing process can function as an imperfect alternative. The argument is that microcredit allows households to convert small amounts of money today into the promise of large future cash flows, just as savings does (Rutherford 2001). In this way, saving and borrowing are substitute activities. 

To the extent that this is generalizable, as poor households gain more access to better saving products, will they switch away from credit products? What will this mean for the microcredit business model? Answering those questions requires having a better understanding of how borrowing and saving interact.

The series has been compiled as a framing note on the FAI site and will be available later as part of a collection of studies to be published in a forthcoming book.