Wednesday, September 2, 2009

Frugality and the Economy

The recent boom was remarkable in the record levels of consumer spending and consumer debt. Against a backdrop of rising house prices, consumers undertook record levels of personal debt leading to a fall in personal savings rates. In both the UK and US, personal saving rates fell close to 0%.

Since the housing market and economy abruptly turned, this consumer extravagance has evaporated as nervous householders have looked to pay off debts, increase their saving and save some money for a rainy day (prospect of unemployment).

Even as the US economy recovers - (e.g. manufacturing output bouncing back and confidence returning), there appears to be no return to the mantra of borrow and spend. The US consumer has gained a taste for frugality and it may last for a lot longer than just this period of economic recovery. In the long run, the change in attitudes of consumers and banks may prove to be at least one benefit of this current economic crisis.

This new preference to save can be seen through the rise in saving rates. After having mostly declined for the past 15 years, the US saving rate reached a low of under 1% in the first half of 2008. Since then the rate has increased back to 4.2% in July. This is still low by historical standards, but, it does come during a period of unemployment and falling incomes (some people are having to run down savings because of a worsening situation). It is a similar story in the UK, where last month consumers reduced their total debt for the first time in several years.

What is Impact of This New Frugality and Higher Saving Rates?

In the short term, the desire to save makes monetary policy less effective. It is the propensity to save which partly explained why 0% interest rates didn't encourage spending. This is why the Fed and Bank of England resorted to unorthodox measures to boost aggregate demand. If saving rates continue to rise sharply during the recovery, it will mean they will need to be careful to avoid prematurely cutting off demand. (see: Paradox of thrift for more detail on the problem of rapidly rising saving rates)

In the longer term a rise in savings has more benefits.
  • Will help reduce the persistent US current account deficit and the long term imbalance with other countries (primarily China and Japan)
  • Higher savings may encourage a more balanced economy with lower spending but relatively higher levels of investment.
  • Cutting the addiction to debt is definitely good in the long term. With high levels of indebtedness it makes the banking sector vulnerable to default and consumers are vulnerable to rising interest rates. It appears that many have been burnt by the boom and bust asset bubbles and now consumers are more cautious about getting into debt and believing 'the good times always role'
So, as is often the case, virtue (saving) is good; but maybe not too much too soon...

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