Discouraging saving = encouraging poverty

I've just been reading Mish. He has a classic line:

Worrying about this economy slipping into recession is like worrying that your pet goldfish is going to die when it is floating dead on top of the tank.

I love Mish - he's fearless and forthright even though I disagree with him on important issues. Here's some more of Mish, following the above quote:

Economists should to be thankful that consumer spending is dropping. Unemployment is soaring, people have been living beyond their means, and if consumers keep spending recklessly, eventual defaults and bankruptcies will be that much higher.

From the point of view of retailers, this Christmas season may well be one of the worst for decades. From the point of view of an economic recovery, reduced spending is actually a good thing, not a bad one. It's long overdue for the "gotta have it now" generation to show a little fiscal restraint given the pool of savings sorely needs to be replenished.

The US needs to become a nation of savers once again, and that is just what is going to happen, whether Bernanke or anyone else likes it or not.

I've been thinking through this issue and I think that one attractive narrative that people have latched onto is the idea that some level of moral failing has caused this financial mess. Mish helps perpetrate this in these paragraphs, describing a "gotta have it now" generation who have "spent recklessly". The recent footage of Richard Fuld from Lehman Brothers appearing before a Congressional committee reminded many of the Enron fiasco.

There's no doubt that people have been reckless in the face of cheap credit over the last few decades, but I really don't think that this recklessness is somehow to blame, or that an entire generation of people can be classed as reckless and spendthrift.

The problem is that the road to financial ruin isn't always well signposted. "Abandon all hope ye who enter here" was not the signpost that people recklessly ignored. On the contrary, the signposts actually read "walk this way if you want to be financially prudent".

Take the tragic case of this man and his family. An MBA in finance and experience working for major accounting firms was not enough to prevent Karthik Rajaram from losing his job, wallowing in a pit of depression and then taking a gun to himself and his family. While the responsibility for this tragedy lies with Rajaram and him alone, I would nevertheless argue that, had things been different and the current economic crisis not happened, he and his family would still be alive today and he would probably still have a reasonably good job. While it is true that Karthik Rajaram's reaction to his plight was monstrous, I do not believe that his plight was brought about by financial recklessness on his part.

So too do I see the current plight. It is not the moral failing of America as a people that caused this crisis. While I don't see Americans as being paragons of virtue I don't see them as devils in disguise either.

So what is the problem then? If not morality and greed then what? It is structural - America's (and the world's) economy created this crisis because something within the system created the conditions that led to this disaster. This is important to realise because, when the time comes to stop reacting to daily crises and start examining why the failure occurred, there will arise a series of solutions that will help prevent a similar event occurring again.

It is not as though market capitalism has failed - as far as I am concerned market capitalism fails all the time. Abandoning capitalism for, say, Communism is about as judicious a decision as eating pebbles to cure an infection that has developed a resistance to antibiotics.

Put simply, the current crisis was caused by people with lots of money who invested it in the wrong thing. The people thought they were doing the right thing because the numbers looked right, the ratings agencies gave AAA ratings, the majority of respectable financial analysts said is was the best thing to do and the Joneses next door were making a killing from it. Herd behaviour? Yes. But herd behaviour that had careful planning behind it.

The structural problem resulted in the market investing unwisely. Investments were made in particular areas (shares, property) that seemed wise at the time but ended up going bad. While we may expect high return investments to be highly risky, the same could not be said for low return investments - which are now in free-fall too.

Mish nails it on the head when he says that "The US needs to become a nation of savers once again". I fully agree. Moreover, the historic, long-term drop in savings rate is the main cause of this current crisis.

But let's just go back a few years. If Mish and I are right in arguing that America should save more, what would people 3-4 years ago have said in response? "I am saving" they would say, "I have a mortgage and I am investing in my house, which is rising in value". And there the problem is - investing in housing had replaced saving.

It's at this point that I have to point out what saving actually is. It is not using your surplus cash to invest in shares and property. It is not using surplus cash to invest in managed funds. Savings means retaining your surplus cash as cash - it sits in your bank account or in a cash management trust or time deposit.

Cash ought to be the safest form of investment. There has to be some sort of low or zero risk investment that people can make. It's not wrong to invest in shares or property - it's just important that a percentage of surplus cash remain in cash form.

Having money tied up in cash is not very sexy. The interest you gain on it is nowhere near as potentially rewarding as a higher risk investment. Yet the issue is not whether cash investments replace other investments - but having a healthy mix of the two.

Cash investments are meant to be safe. They are not meant to reduce in value. If you have $10,000 sitting in a cash management trust you are not meant to watch it drop down to $9000. Any cash you have sitting in an account that remains uninvested in anything else should, at the very least, have the same value when you withdraw it as when you deposited it.

And cash - savings - is useful as a "safety net" when things go wrong. Everyone knows the importance of having more cash flow available than what you need normally because of the danger of unforeseen events. The best place to access this cash flow is from interest-bearing accounts that you have saved up over time (rather than, say, maxing out your credit card).

Yet here is where the structural problems come in: Americans (and many others) did not invest their cash surplus in savings but put them into risky investments that have since lost money. This was not a moral failure, but a practice that the entire economy encouraged.

I argued early in September that negative real interest rates under Alan Greenspan between 2002 and 2005 was the cause of the housing bubble. I remain convinced of this despite what others may say about the influence of Fannie and Freddie or policies under Jimmy Carter or the alignment of the planets. Yet the housing bubble seems to have triggered a wider contagion - one that I believe has been waiting to occur for about a quarter of a century.

The housing bubble occurred precisely because Alan Greenspan and the Fed ran negative real interest rates. This punished anyone who kept cash, since rises in inflation outweighed any interest gained (and interest rates on cash management accounts depend upon the Federal funds rate). The only choice for the economy was to invest in something that increased in value - and let me point out that this was rational behaviour. The intent was certainly rational, but the direction of investment was not. Instead of investing in property between 2002 and 2005, it should have been more attractive to increase personal savings (increasing the amount of money saved up in cash). The only way for this to have happened was for inflation to be lower than interest rates.

This is the reason why it was so important for Alan Greenspan and the Fed to have raised interest rates after 2002. Not only would this have lowered inflation and increased the attractiveness of saving, but it would have also resulted in positive real interest rates. Had the economy siphoned funds to savings rather than property then the current crisis would not have occurred. Yet the reason why the economy did not do this was because rational behaviour dictated that money should only be invested in something that increased in value - by keeping rates low and running negative real interest rates, the Fed made saving irrational.

But go back a few more years - back to the tech boom of the late 1990s and the subsequent popping and recession in 2001. In the years that the long boom grew, the market obviously made rational decisions to invest less in saving and more into tech shares. Yet during this period, real interest rates remained positive.

But again the problem remained - the market rushed to invest in something that would increase in value despite the fact that real interest rates were positive. I would argue yet again that if the Fed had chosen to keep rates higher during that period, the market would've siphoned more funds into cash rather than creating an investment bubble.

So what is the problem then? What is this structural problem? It is that interest rates have been kept too low, encouraging the market to put too much money into investments that eventually failed.

In summary, therefore, are my solutions:

1. Ensure that real interest rates are positive at all times.
2. Monetary policy should be geared towards ensuring absolute price stability - that is, zero inflation - to encourage savings rates and discourage too much investment in high risk ventures.
   

Had this been the Fed's policies from the early 1990s onwards, there would not have been either the tech boom and bust nor the subprime mortgage crisis and today's credit crunch. GDP growth during this period would have been lower, certainly, but considering the potential cliff that GDP is likely to plummet in the present, this would have been a better outcome. Moreover, savings rates would have been high and credit market debt would have been more sustainable (especially in light of this frightening graph).

I honestly don't know what is going to happen to the world economy over the next day, month or even year. What I do know is that, once a recovery is underway, new policies and paradigms will need to be explored to prevent this financial horror story from occurring again. Increasing household savings is one major step in this direction - and this is best handled by using interest rates to affect broad market behaviour rather than creating legislation to force people to save.

And that is a far better solution that complaining about the supposed moral failures of CEOs and a whole generation of people.