The Solow conundrum: How to increase savings?

Today, I looked at growth theory as set down by Robert Solow. I was not looking forward to it primarily because I find one of the core ideas upon which it is built to be such a head-scratcher. Solow contends that people, by saving more, can increase their investment and thus their capital per capita and thus increase their growth. This growth though is not durable because capital accumulation creates a diminishing return and eventually the rate of depreciation of capital will equal the rate of capital accumulation and the net result will be 0 (see diagram). The puzzling idea upon which this is based is that every individual instead of spending their revenue saves it and transforms it into investment capital. It is based on the concept that there is a natural rate of output that is endogenous to both saving and spending rate. This is clearly not true in the short term. Decreasing C in no way affect S. Instead you will have a paradox of thrift whereby as C decreases Y decreases and the saving rate will not be affected. So how does the savings rate increase?

My first solution was to say that perhaps what we are talking about is an open economy and consumption is really foreign consumption. This gets rid of the paradox of thrift problem, and the saving rate will certainly increase in this case. This though is not the answer: The investment capital being saved is foreign capital: Buying a foreign factory is not going to help local factory workers be more efficient.

I next decided to change focus. Perhaps savings is the wrong side of the equation. We should be looking at Investment. If investment increases, the savings rate would certainly have to increase. The easiest concept is to imagine the government, borrowing money and investing it at a higher rate. It seems though that in this case, interest rates would go up and the government investments would just crowd out the private ones. The savings rate would not necessarily go up.

The only way saving can go up, is by incentivizing people to increase their investments. For example by decreasing the risks involved with investing. If people feel more secure that they won’t be wiped out in a financial crisis, with FDIC insurance for example, they would undoubtedly be willing to put more money in the bank which could then be lent out and resaved thus increasing the total amount of investment and savings. Next if people could be made to believe that the marginal efficiency of capital will increase in the near future, they would be certain to invest more of their money. If the marginal efficiency of capital increases, investments will increase. This of course is the point that Solow was trying to get at, only through technological innovation, which increases the marginal efficiency of capital, can growth be maintained.