The Diminished Incentive To Save
by Martin Hutchinson March 01, 2010
Ben Bernanke reaffirmed last week that short-term interest rates would be kept at their current ridiculously low rates for “an extended period.” Apart from the danger of inflation this produces there is another problem: Fed monetary policies in the last decade have done great and possibly permanent damage to the U.S. propensity to save. The devastation that this will wreck on the economy is slow-moving, but potentially ruinous.
During the 1990s (defined as 1991-2000), the average U.S. rate of inflation was 2.67%, while the average yield on 3-month U.S. Treasury bills was 4.69%. Thus the average real rate of return on 3-month Treasurys, about as close as you can get to a truly riskless asset, was 2.02%. Historically, that’s just about the normal figure. The yield on perpetual British 2½% “Consols” in the 19th century bottomed out at 2.2% in the Golden Jubilee year of 1897, but Consols – being a long-term instrument – contained substantial price and liquidity risks, even in a period when the Gold Standard prevented inflation.
Readers of this column will remember that I have always maintained that monetary policy became excessively loose not in 2002, as is commonly assumed, but in 1995 – based on the excessive growth rate of M3 and other measures of broad money supply from the early part of that year. However, two countervailing factors caused real short-term interest rates to remain around their normal 2% level during the second half of the 1990s, in spite of this monetary sloppiness.
First, the U.S. economy was in a period of wild speculative boom, with rapid economic growth and huge capital investment. That would normally have tended to increase the demand for capital, raising real interest rates far above their normal levels. Second, in the late 1990s, there was an extrinsic deflationary shock from adoption of the Internet and modern communications technology, and its use to make global outsourcing of goods and some services much easier and cheaper. Consumer price inflation dropped sharply, to 1.7% in 1997 and 1.6% in 1998, well below its level earlier in the decade, while interest rates were slow to adapt to this unexpected downtick in inflation. Those two factors kept real interest rates at around their long-term equilibrium level of 2% or so, rather than dropping through excess money creation.
After 2000, the inflation-suppressing effect of the new technologies continued, so inflation remained quiescent, averaging 2.55% annually in 2000-09 compared to 2.67% in the 1990s. However, the continued rapid money growth produced a much lower risk free interest rate. Three-month Treasury bill yields averaged only 2.70% during the decade, so real interest rates were only 0.15% per annum. From 2002, the effect was even more pronounced; real interest rates on 3-month T-bills in the eight years from 2002 through 2009 averaged a negative 0.34%. Bear in mind that nominal interest receipts are taxable, and you can see that the risk-free return to savers was substantially negative throughout the decade.
If savers are not rewarded for saving, are even penalized for it, then it is not surprising that they don’t save. The U.S. savings rate declined from its already mediocre rate of 8% from the middle 1990s, falling perilously close to zero in 2005-07. It rebounded in the 2008-09 recession, as consumption habits finally changed, but there are now strong signs that the dolce vita of Caribbean holidays and long weekends at casinos is recapturing those Americans who still have jobs – only the McMansion and Hummer fetishes seem to have diminished. The savings rate has fallen below 5% and appears likely to decline further.
This is not surprising; the real return on Treasury bills was minus 2.65% in 2009. U.S. savers who avoided risk were thoroughly penalized for their accumulation. Even though savers would have made very good money by investing in stocks in the early months of 2009, the losses they had previously suffered on their stock portfolios since late 2007 or on their houses since 2006, together with the difficulties in the job market, made investible funds scarce. Jean-Paul Getty said in the 1950s when asked how to become a billionaire “Start as a millionaire, stay liquid, and buy in 1932.” The middle part, given the timing, is the difficult section of that assignment!
Beyond interest rates, there are other factors that have tended to depress U.S. saving in recent decades. Means-tested benefits such as Medicaid tend to depress savings rates, since savers naturally realize their savings may eliminate them from these benefits (the British system whereby nursing homes are free for those who have used up their savings is equally damaging in this respect). Persistent inflation and taxes on nominal incomes make tax rates very high on real gains in wealth or, in times when real returns are near zero, impose taxes on income that is non-existent in real terms, merely a return of capital. Social security and other benefits that appear to provide for old age reduce savers’ need to accumulate capital, while the elimination of money purchase pension schemes and their replacement by generally stingy 401(k) plans has depressed actual saving, however much it may have increased the need to save. In summary, it is surprising that U.S. savings rates are not in reality substantially negative. Indeed, after a few more years of ultra-low interest rates and rising inflation they probably will be.
It has been fashionable since the time of John Maynard Keynes to regard saving as unimportant, even undesirable. The consumption driven view of the economy, by which consumers’ irresponsible shopping sprees drive economic growth is, however, on inspection fallacious. Indeed, studies of economic emergence from poverty, both in industrialized countries and emerging markets, have shown that savings rates, among the middle classes rather than the rich, have a crucial impact on the speed and health of economic growth. Countries with low savings rates either do not grow or, if they do grow, do so sporadically with frequent debt crises and prolonged recessions. One need only look at the economic history of the resource-endowed Argentina and compare it with the resource-poor South Korea, or indeed to the enormous economic successes of Japan to 1990 and China now – both countries far poorer than Argentina in 1930.
The principal requirement for successful economic development is the development of a middle class with adequate savings. You can see this in 18th century Britain, which developed the Industrial Revolution primarily because it had relatively high living standards and consequently high savings. You can see it in the recent development of the countries of former Yugoslavia, the most successful of which has been Slovenia, where savings could grow in Austrian bank accounts, essentially tax-free. Conversely Serbia, far from Austria and subject to hyperinflation, and Bosnia, where savings were expropriated by Serbia in 1991 and never replaced, have been much less successful. Croatia and Macedonia, whose middle class savings were expropriated in 1991, but were replaced by the local governments through bond schemes in 1995 and 2000, have enjoyed at least modestly increasing affluence, far more so than the luckless Bosnia, relatively affluent in 1985 and impoverished today.
The connection between middle class savings and economic growth is both economic and social. Economically, the pool of savings accumulated by the middle classes forms the principal source of seed capital for small business, itself the principal source of both employment and economic growth. In times like the present, when the banking system pulls back from the small business sector, the existence of ample middle class savings makes the difference for most small businesses between survival and death. In countries such as China and Japan, the banking system can restrict itself largely to infrastructure and the larger corporations, while entrepreneurship is financed by savings. In low-savings countries like the United States and Argentina, banking crises become hugely damaging, because the base of middle class savings is not there to replace the banks.
The most extreme historical example of savings destruction happened in 1923 in Weimar Germany. Middle class savings were wiped out by hyperinflation, and that destruction of middle class virtues and living standards led directly to the emergence of the Nazi regime a decade later.
The United States today is in the position of Weimar Germany about 1921, as I have pointed out before and as has been elegantly illustrated in a new paper by Societe Generale’s Dylan Grice. On the surface, the economy is relatively prosperous, having recovered well from the devastation of a few years previously – obviously the losses caused by World War I having been far worse than a mere banking crash. In both 1921 Germany and 2010 America, the fiscal authorities have propped up the local economy through large budget deficits, while the monetary authorities, Rudolf von Havenstein’s Reichsbank and Ben Bernanke’s Fed, have abandoned conventional economic restrictions and pushed monetary expansion to extreme levels in an effort to reflate the economy as rapidly as possible. In both countries, the stock markets are doing quite well – by 1921 the German stock market had risen by over 100% in real terms from its lows. In both countries, savings are rapidly diminishing in real terms, as it has become impossible to maintain the value of savings other than by speculation.
We know what happened in Weimar – hyperinflation, the wipeout of savings, a few years of unsteady prosperity and then economic and social disaster. Only after 1945, when a wiser leader with experience of both the Weimar and Nazi disasters created a society and a Bundesbank charter in which preserving the value of middle class savings was paramount, did Konrad Adenauer’s Germany finally re-take the economic preeminence the country had enjoyed under Kaiser Wilhelm II.
Von Havenstein was known as the “Money General” – a title that could well have been applied by his admirers to Bernanke as the 2009 market and banking recovery took hold. Our own von Havenstein has presided over a policy that has hugely damaged the savings base of his society, and the middle class virtues of prudence and thrift that in a high-savings culture produce rapid economic growth. Whether his policies will in the long run produce only anemic growth, persistent high unemployment and a gradual decline in living standards, or like von Havenstein’s something immeasurably worse, only time will tell.