Monday, November 24, 2008

Economics of Saving


To Save or Not To Save?

A prominent feature of the past few years has been a marked decline in the savings ratio. The UK Savings ratio has fallen from 13% in 1992 to a record low of 1.1% in September of this year 2008. In the US, saving ratios have fallen by a similar amount.

Many economists suggest that the current financial turmoil reflects a lack of prudence by both consumers and financial institutes - and this is reflected in a falling savings ratio. So why was the US Treasury proposing to use $25 billion to help boost US consumer credit? Is saving good or bad? Should we really be encouraging people to spend more when the economy actually needs a higher saving ratio?

The decline in the savings ratio reflects:

  1. Rising House and asset prices. As house prices rise people remortgage and feel more confident to spend.
  2. Increased willingness to borrow and take on debt.
  3. Higher confidence about economy.
  4. Relatively low interest rates

Problems of Low Savings Ratios

  1. The decline in the savings ratio reflects the boom years where people borrowed heavily to finance spending and get on the property ladder at any cost. Rather than save a deposit for a house, people would get a 95% or 100% mortgages. This exacerbated the boom in prices and now is leading to negative equity.
  2. Consumers have little margin for error. Lower incomes or rising living costs, mean people have little backup.
  3. Current Account deficit. It is no coincidence that countries with low saving ratios tend to have current account deficits. This is because with low savings, there is high spending on imports. Large current account deficits increase the likelyhood of currency devaluation such as US dollar since 2000 and Iceland this year.
  4. Is reflected in banks balance sheets. The problem of Northern Rock is that they financed the majority of their mortgages not by savings and customer deposits but by borrowing from other banks.
  5. Low saving Ratios imply less investment. It reflects a choice to have greater living standards now at the expense of the future.

So Should We save More?

In the long term, a higher saving ratio would be desirable. It would help shift the economy from a consumer led growth to a more balanced economic growth. However, a sharp rise in the savings ratio at the present moment would be damaging. Look at the experience of Japan. Japan have a huge current account surplus and huge array of foreign currency reserves. But, it led to stagnant growth for the next 10 years and a national debt of 195% of GDP. (updated)

In a recession, we don't want spending to stop completely. If the savings ratio suddenly shoots up, the decline in consumer spending would be much greater and the recession deeper. Keynes pointed to a phenomena known as the 'paradox of thrift' - In a recession people instinctively save more, but this makes the recession worse.

For the next 12 months, we want to avoid a very painful slowdown. But, when the economy recovers, we need to try and create a situation which encourages a higher level of saving. Above all, we want to avoid another credit led boom. But, just at the moment increasing the savings ratio is not our highest priority.
  • To paraphrase the words of Saint Augustine - "Lord, make us virtuous savers - But Not just Yet".
(The actual quote from Augustine's Confession "Lord, make me pure, but not yet")


Lawrence Low said...

Hi, good job for all the postings. I just wonder as why the postings on your Blogs & Economic Essays are now the same while previously they were not?

Tejvan Pettinger said...

Hi Lawrence.

Thanks for your feedback.

I tend to write longer essays on the essays and answer readers questions.

Sometimes I link from the blog to the essays just to highlight a long essay, I wrote. I don't know whether people read both or not.

Lawrence Low said...

Thanks for the fast response. Of course they are. To be very frank I'm always chasing both your blog & economic essays everyday when i back from work. For your information, I'm from Malaysia & I'm very keen to keep myself updated what is evolving in UK & the rest of the major economies.

It would be really great & I seriously believe that many of your fans will want things back to normal

Lawrence Low said...

Hi, it's me again. I just wrote a long reply to your message (not sure if it appears but I can't see it under Comments)

Of course I would love to read different postings from both side, & I also believe that there are many loyal readers (but silent)that would like to see things back to normal. For your info, the first thing I always do after back from my work, is switch on the computer & look for economicshelp & check out what you have posted on issues in UK, US or around the world

Tejvan Pettinger said...

Hi Lawrence. Sometimes I like to cover topics twice. For example, I have talked about why saving ratios declined on /blog But, in this post, I wanted to develop this idea to say whether declining savings ratio is a good or bad thing. Anyway thanks for your input.

crs said...

Did you really look into this? Japan's savings ratio actually has declined significantly from mid-teen's to low single digits currently.

crs said...

Did you really look into this? Japan's savings ratio actually has declined significantly from mid-teen's to low single digits currently.

Tejvan Pettinger said...

Hi crs,

Yes, I updated post after looking into Japanese saving rates.

The high savings refers to high foreign currency reserves Japan has been accumulating through large trade surpluses.