The US Savings Crisis

America is in a crisis when it comes to savings. For the first time in a long time, American households have reached "negative saving" - they are dipping into their cash reserves and spending it.

The reasons why households (as well as businesses) save money is to "put it away for a rainy day" - in other words, there is a deliberate choice to put off spending money in the present in order to spend it in the future. Saving is a normal economic activity.

There is, naturally, extremes that have to be avoided. If there is too much saving, less money is allocated to normal economic activity and causes an economic downturn. In this sense, an overdose of saving can actually be very harmful to an economy. On the other hand, if the savings rate is too low, then the economy is far more vulnerable to any economic shocks that happen - ordinary households would not have the "safety net" of savings available to cushion the blow.

The problem is that saving money differs from culture to culture and from country to country. While America (and to a lesser extent, my own country Australia) are reaching dangerously low savings levels, the Japanese, the French and other peoples are saving quite well thank you very much.

Another problem is that the strict definition of saving involves having money set aside. There is no doubt that many people choose not to set aside money because it is much better for them to invest in something else, such as their house or in the stockmarket. In this sense, although "savings" may be low, there are plenty of people who see their investment in stocks and property and other things as an alternative form of saving. Given the choice between cash and the mortgage, many people would naturally choose the mortgage since more money will be gained in the long run - or so they believe. For example, if the cash rate is 5% and the value of their property is going up 7% per year, then choosing to put the money into the house is a no-brainer.

It's this final issue that is causing historically low savings rates. Rather than setting aside cash, households are investing in other things, as well as increasing their consumption.

Should we be concerned about this situation? Yes. We should be very concerned.

Saving is the main way that households can cope with any future downturn. While the price of other assets may plunge, the value of money will stay more or less constant. The reason this is so is because of the Federal Reserve, who will not let money devalue more than it needs to. When money devalues, inflation is the natural result. To control inflation, the Fed raises interest rates. The Fed sees price stability as one of its main goals, so while the economy may be suffering, at least you can still buy things with your dollar.

But the Fed backs nothing else - not property nor stocks, only the dollar. If households have invested money into property and stocks and a recession comes along that knocks these investments out, the Fed can do nothing about it directly. The only mechanism the Fed has is controlling the money supply, and when faced with a recession the Fed usually increases supply by dropping interest rates - a process that helps, but which will not guarantee that property and stock prices return to their previous state. The upshot of this is simple - if a recession comes along, those who have not got sufficient cash reserves will be hurt the most.

So what is the solution? In today's New York Times, an editorial focuses upon a bold new plan that will increase the national savings rate. The basic plan is to set up an "automatic individual retirement account", whereby employees set aside a small amount of money each week that is directed towards this particular account. The plan, which has been proposed jointly by the Heritage Foundation and Brookings Institution, has received a great deal of praise from the NYT editorial.

But this plan fails to take into account one very basic thing - the reason why savings is so low. Rather than try to understand why such a rate is low, people have instead tried to focus on setting up schemes to solve it. But in order to properly solve such a problem, one must understand why it exists in the first place.

The simple reason why the national savings rate is low is because households have decided that there are more valuable things than cash. I have mentioned two - property and stock - but there are a multitude of others. In order to increase the national savings rate, money itself needs to become more valuable. When this occurs, the market will naturally respond by increasing its cash reserves.

So how can money be made more valuable? Again, the answer is simple - it is the actions of the Federal Reserve that give money its value. It is therefore up to the Federal Reserve, not schemes and plans from various thinktanks, to solve this problem:

The best way to boost national savings is to increase interest rates.

At this present moment in time, America, Australia, the U.K. and a number of other countries are experiencing a boom in asset prices. Yet such a boom will naturally come to an end. The reason why such a boom has taken place is, I believe, because the "target rate" of inflation that central banks have been using has been too generous. While inflation rates of 2-3% per year sound normal, I would argue that such a practice has inevitably led to this asset-price boom - a "bubble" if you will. The "bubble" has not been quick in inflating, but it has grown to become a very serious problem. If Central banks lowered their inflation targets (I would argue for zero inflation), bubbles such as these would be exceptionally difficult to form, and money would be valuable enough for the market to have a healthy savings rate.

Unfortunately, raising interest rates causes problems of its own. In the current environment, there is no doubt that setting rates high enough to keep inflation at zero will result in a recession. However, I have always argued that the effects of a recession are worse the longer it is delayed - which, in this instance, means that the recession caused by inflation-less monetary policy will not be as bad as the future recession that occurs due to the asset-price bubble popping.

But, of course, what I am arguing goes against the tide of modern economic thinking - yet there is no doubt that the best solution for increasing the savings rate would be to make cash more valuable in relation to everything else... and to do so would require a shift in thinking within the world of monetary policy. After all, monetary policy at the moment is hardly preventing the horrific national savings rate.

From the Osostrian School Department

© 2006 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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Paul W said...

Neil, a fascinating post.

I always like reading your heterodox economic analysis. It makes a change from the Neo-Classical indoctrination I received in stage 1 economics.

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