Economist's View

A Lasting Recovery?

Olivier Blanchard argues that global imbalances must be resolved in order to put the world economy on a sustainable path to recovery:

What is needed for a lasting recovery, by Olivier Blanchard, Commentary, Financial Times: In 2007, worried about the growing size of current account imbalances, the IMF organised multilateral consultations to see what should be done about it. There was wide agreement that the solution was conceptually straightforward. To caricature: get US consumers to spend less. Get Chinese consumers to spend more. This would be good for the US, good for China, and good for the world. ...

It was an impressive piece of global macroeconomic planning. But, at least until the crisis, not much happened. ... And, since the beginning of the crisis, dealing with global imbalances has gone down the priority list. ... As the crisis evolves, however,... the issue of global imbalances is likely to return to the fore. Again, a central role will have to be played by the US and by China.

Using Inheritance Taxes to Promote Equal Opportunity

Michael Kinsley is mystified by ten Democratic senators:

Democrats for Rich Heirs?, by Michael Kinsley, Commentary, Washington Post: ...Meanwhile, the Senate is considering what to do about the estate tax. It is scheduled to be abolished next year, in one of several landmines the Bush administration set to go off after it left town. Obama proposes to reinstate the tax, at a 45 percent rate, on estates worth more than $3.5 million. Since there's no tax on what you leave to your spouse, married couples could pass on $7 million before needing to pay a dollar -- or needing to consult a lawyer who can use loopholes to save millions more.

The House has passed this measure as part of the budget. In the Senate, there's trouble. Ten Democrats have joined the Republicans in calling for a $10 million exclusion and a 35 percent rate. This is amazing. The number of people who leave estates of even $7 million is minuscule. The number leaving more than $10 million is smaller still. Yet to save these very few very wealthy people a small fraction of their estates, these senators are willing to hand their party's president an embarrassing defeat. Why on earth?

Oh, small business blah blah blah. ... To be affected by the estate tax, a business must be owned by someone of large means: at least $7 million. ...

But why the populist fury over those AIG bonuses of a few million dollars while no one seems to care much about billions being transferred through inherited wealth? The obvious answer -- that there's a difference between what people do with our hard-earned money and what they do with their own hard-earned money -- isn't actually as persuasive as it seems.

Perusing the Forbes 400 list of America's richest people, it's striking how few of them made the list by building the proverbial better mousetrap. The most common route to gargantuan wealth, like the route to smaller piles, remains inheritance. ...

Dozens of Forbes 400 fortunes derive from the rising value of land or other natural resources. These businesses are fundamentally different from mousetrap building. Land does not need to become "better" to increase in value, and that value increase doesn't produce more land. Yet other fortunes depend directly on the government. The large fortunes based on health care and pharmaceuticals would not exist if not for Medicare and Medicaid. The government hands out large fortunes even more directly in forms as varied as cable-TV franchises; cellphone licenses; drilling, mining and mineral rights; minority small-business loans; and other special treatment.

Most important, every American selling anything benefits from doing so in the world's richest market. An American doctor earns many times what the same doctor would earn in, say, India. This is not because he or she works many times harder. ... It's because we are a richer society, for reasons the American doctor had nothing to do with.

The debate over whether the estate tax should start at $7 million or $10 million is largely symbolic. That makes the push by those 10 Democratic senators for the higher amount even more mysterious.

Via Brad DeLong:

Think Progress: Lincoln’s $250 billion estate tax plan would cut taxes for only 60 ’small businesses.’: Last week, 10 Democrats in the Senate joined all 41 Republicans in voting for a $250 billion proposal to cut estate taxes... Touting the tax cut in a press release, Lincoln claimed that it was “aimed at farms and small businesses.” However, according to an analysis by the Tax Policy Center, Lincoln’s $250 billion proposal would save just 60 small businesses or farms from the estate tax:

An always charged issue is how the estate tax affects small farms and family-owned businesses. We estimate that under the Obama proposal, 100 family farms and businesses [a year] would owe tax.... The Lincoln-Kyl proposal would cut the number to 40.

According to the Congressional Budget Office, “almost all such estates are able to pay the tax bill without having to sell business assets.”

To try to overcome the political opposition, and to try to meet a worthy goal, I would increase and broaden the tax, and then earmark the revenues specifically for programs designed to promote equal opportunity, e.g. Head Start programs, funds to allow anyone to attend the college of their choice without running up large debts, or alternatively to help to start a business, and so on. To further help with the political opposition, the collected funds, or more precisely the programs the funds support, would be made available to everyone on an equal basis.

Mortgaging the Nest Egg

This is not a good sign. A lot of people are borrowing from their retirement accounts to pay off debt:

Borrowing from the Nest Egg, by Lane Kenworthy: This news is discouraging, but hardly unexpected. According to a “Marketplace” report, a survey by the Transamerica Center for Retirement Studies (pdf here) finds that the share of workers borrowing from their 401(k) retirement funds increased from 11% in 2006 to 18% in 2007. Nearly half of those taking out such loans in 2007 cited the need to pay off debt, compared to a quarter in 2006.

Stagnant wages and salaries, most spouses already employed, rising health care and college tuition costs, higher mortgage debt loads, and falling home values mean lots of American households — including many middle-income ones — are pinched financially. The late 1990s economic boom lessened the strain for a while. Then home equity loans helped. More recently, credit card usage has jumped. Borrowing against retirement savings is the logical next step.

See more discussion here, here, and here.

This is why I wonder about the long-term participation rate in "opt out" retirement accounts that are being promoted as a way to deal with the retirement security problem. How many people will opt out of these accounts when economic conditions for the household deteriorate temporarily for some reason? And once they opt out, will they opt back in? People who are motivated enough to borrow against their retirement accounts - almost one fifth in 2007 - would also be motivated enough to opt out of an automatic savings plan. Many of the studies, at least the ones I have seen, do not track people over long periods of time where this type of deterioration would be present, and they do not follow people through a recession when the pressure to opt out would be greatest. I'm not saying we shouldn't have these programs, they do help some people save, and even if some people opt out at least they have a source of funds to use when times get tough. The point, though, is that the people most likely to opt out are the very ones we would like to see participate in savings programs so that they have more than just Social Security available during their retirement years. Because of that, we should be careful not to place too much emphasis on opt-out types of mechanisms for solving the retirement security problem. These accounts may not provide as much of a boost as we hope to key segments of the population.

Update: Megan McArdle follows up with comments on forced saving as a solution to this problem.

Richard Baldwin: Feldstein’s View on the Dollar

Richard Baldwin reviews Martin Feldstein's May 2007 predictions about the fate of the dollar, predictions he says are "looking pretty good at the moment":

Feldstein’s view on the dollar, by Richard Baldwin, Vox EU: President Kennedy said “Victory has a thousand fathers, but defeat is an orphan.” If the dollar’s slide is a defeat, then contrary to Kennedy’s wisdom, this defeat has a thousand fathers. Any number of observers now tell us that it was inevitable. One of my hobbies is to go back and see who saw it coming. Not from a pure forecasting perspective, but from an economic logic perspective. Who understood the key economic factors in advance and had the conviction to write them down? Marty Feldstein is one of those and this column presents my interpretation of the economic reasoning in his May 2007 paper.[1]

"Supplementing Social Security"

Rahm Emanuel has a proposal to increase personal savings:

Supplementing Social Security, by Rahm Emanuel, Commentary, WSJ: ...In the past two years, America's personal savings rate reached its lowest level since the Great Depression. And in comparison to other industrialized countries, the United States ranked second to last in personal savings.

Most people intuitively understand the importance of saving as a way to finance education or a dignified retirement, but the benefits to the overall economy are also important. An increase in savings enlarges the pool of capital...

Every American who works ought to have the chance to save. But today ... nearly half the work force ... lack[s] access to an employer-sponsored savings plan ... for retirement. At the same time, too many who have access to a savings plan contribute too little or don't participate... In addition, Americans don't start saving early enough. ...

Over the past 30 years, we have offered a blizzard of tax initiatives to encourage individuals to save for their retirement. .... Yet the national savings rate has plummeted. ...

In the last Congress, I proposed legislation that took a different approach. Instead of offering a new tax subsidy, my proposal helped companies automatically enroll employees in their 401(k) plans, rather than relying on workers to fill out the forms necessary to participate in a plan. ... If we make saving simple by limiting the amount of time, effort and decisions that people have to make, we can dramatically increase the number of people who save. In short, simplicity trumps choice.

Making saving easy is half the battle. The next step is to make saving universal. ... Republicans have long advanced the idea of personal accounts inside of Social Security. An accounts-based system that supplements, not supplants, Social Security can work. Democrats have argued that 401(k)s and personal savings are important supplements to Social Security, but we should ensure that fees are low and that lower-income Americans have the same opportunity to save that upper-income Americans enjoy. ...

I believe we should create Universal Savings Accounts. Like 401(k)s, the accounts would supplement Social Security. Employers and employees would contribute 1% of paychecks on a tax-deductible basis. Additional contributions could be made to the accounts at the discretion of the company or individual worker.

To ensure low management fees, these accounts would be managed by the private sector but overseen by a quasi-public board that would be given fiduciary responsibility for the types of investment options that workers could select. This system is used by the successful federal 401(k) program, or Thrift Savings Plan, where ... fees have averaged 30 cents for every $1,000 invested. By comparison, the typical mutual fund charges $15.50 per $1,000 invested. ...

To help achieve universal participation and simplicity, employers would automatically enroll their employees in these accounts, allowing employees to opt out if they ... did not want to participate. ... Since low-income workers have the hardest time saving for retirement, we should provide ... a federal tax credit that matches savings put into retirement accounts.

I believe that this type of approach ... is a necessary pre-condition to reforming Social Security. ... American people like the security that comes with Social Security. In order for us to tackle the problems of Social Security, Washington must provide solutions that make the American people feel more financially secure. If this anxiety is not addressed first, neither party will be given the opportunity to constructively address the challenges facing Social Security.

My approach protects the sanctity of the Social Security... It also expands individual savings opportunities outside of Social Security... Strengthening Social Security for the long term will take a sustained commitment to fiscal discipline and bipartisanship, commodities that can become scarce as we head into the presidential election season. But while Americans wait for long-term answers on Social Security, we should act now to give them more ways to start building retirement savings of their own.

I doubt this has much of a chance of going anywhere. I have no objection to the proposal, though the motivation used to sell the program - the implication that Social Security is headed for disaster if something isn't done - is overwrought. I also believe that these types of programs can easily turn from "add-ons" to "carve-outs" down the road which undermines their attractiveness, and I don't think these programs will increase savings as much as people predict once they become widespread and opting out is as simple as checking a box on a computer screen the first time finances get tight.

[Update: Andrew Samwick: A New Approach on Social Security Reform?]

Savings Glut or Money Glut?

Martin Wolf returns to the question of whether global imbalances and other features of the international economy are due to a “savings glut” or a “money glut”:

Villains and victims of global capital flows, by Martin Wolf, Commentary, Financial Times: Fast growth, huge current account “imbalances”, low real interest rates and risk spreads, subdued inflation and easy access to finance characterise the world economy. ...

The two interesting alternative explanations are the “savings glut” and the “money glut”. ... The “savings glut” hypothesis is associated with Ben Bernanke... A substantial excess of savings over investment  ... predominantly in China and Japan and the oil exporters ... has led to low global real interest rates and huge capital flows towards the world’s most creditworthy and willing borrowers, above all, US households. The short-term effect is an appreciation of real exchange rates and soaring current account deficits in destination countries. To sustain output in line with potential, domestic demand in those countries must also be substantially higher than gross domestic product. A country must choose fiscal and monetary policies that bring this result about.

Not only has the US absorbed 70 per cent of the rest of the world’s surplus capital, but consumption has accounted for 91 per cent of the increase in gross domestic product in this decade. Thus excess saving in one part of the world has driven excess consumption in another. ...

In the savings-glut world, governments are responsible for much of the capital outflow. This is either because domestic residents are not allowed to hold foreign assets (as in China) or because most of the export revenue accrues to governments (as in the oil exporters). Either way, governments end up with vast foreign currency assets as the counterpart of domestic excess savings.

In this world, the US is passive victim, excess savers are the villains and the Federal Reserve is the hero. In the money-glut world, however, the world’s savers are passive victims, profligate Americans are villains and the Federal Reserve is an anti-hero. In this world the US central bank is a serial bubble-blower...

The argument is that US monetary excess causes low nominal and, given subdued inflationary expectations, real interest rates. This causes rapid credit growth to consumers and a collapse in household savings. The excess spending floods across the frontiers, generating a huge trade deficit and a corresponding outflow of dollars.

The outflow weakens the dollar. Floating currencies are forced up to uncompetitive levels. But pegged currencies are kept down by open-ended foreign currency intervention. This leads to a massive accumulation of foreign currency reserves... It also creates difficulties with sterilising the impact on money supply and inflation.

In this view of the world economy, savings are not a driving force, as in the savings-glut hypothesis, but a passive result of excess money creation by the system’s hegemonic power. ... Governments of countries that possess the huge trade surpluses ... follow the fiscal and monetary policies that sustain the excess savings needed to curb excessive demand and inflation.

It is no surprise that the Federal Reserve is a believer in the savings-glut hypothesis. But many Asians blame their present predicament on “dollar hegemony”, which is the core of the “money-glut” hypothesis. The big questions, however, are which is true and whether it matters.

My answer ... is that the savings-glut hypothesis is truer, [and]... it does matter. If we live in the savings-glut world, the US current account deficit is protecting the world from deep recession. If we live in the money-glut world, that very same deficit is threatening the world with a dollar collapse and, ultimately, even a return of worldwide inflation.

The savings-glut view is far more comforting. Excess savers will learn to spend, in the end – sooner rather than later, if US spending were to weaken dramatically. But if we live in the money-glut world, the great gains in monetary stability of the past quarter century are at risk. Either way, the present world cannot continue indefinitely...

I will just add that it's possible to have both a high level of savings and a high level of liquidity growth at the same time.

FRB New York: How Worrisome Is a Negative Saving Rate?

Charles Steindel of the New York Fed asks if we should be worried by the negative personal saving rate. The NY Fed's summary gives his answer:

Charles Steindel explains that when the U.S. personal saving rate took a negative turn in second-quarter 2005, it raised concerns that Americans may have to curtail spending and accept a lower standard of living as they pay off rising debts.

However, the risks to household well-being may be overstated, says Steindel. Taking a closer look at saving trends, he argues that the surge in energy costs may have temporarily dampened saving, while the accounting of household income from stock holdings may be skewing saving estimates. In addition, broad measures of saving have remained positive, and household wealth—assets such as stocks and homes, less debt—is on the rise.

Still, Steindel cautions, low levels of household, private and especially national saving may take a toll over the long run and thus bear watching now.

Here's the entire report:

How Worrisome Is a Negative Saving Rate?, by Charles Steindel, Current Issues in Economics and Finance, May 2007  Volume 13, Number 4, FRB NY: The U.S. personal saving rate’s negative turn in 2005 has raised concerns that Americans may have to curtail their spending and accept a lower standard of living as they pay off rising debts. However, a closer look at saving trends suggests that the risks to household well-being are overstated.

We Need More Saving, But Not Right Now

Kash Mansori looks at personal income and saving and doesn't particularly like what he sees:

Personal Income and Spending, by Kash Mansori: Yesterday the BEA gave us some new data about personal income and spending for March of 2007. You can find the news release here, but what I want to focus on today are the reasons why I am worried about the prospects for consumption growth in the coming months.

Actually, my concerns can be summarized in a picture. The following graph shows the annual growth in consumption and in labor compensation, with both series adjusted for inflation using the PCE deflator. The red line then shows the savings rate for US households.

As I've discussed before, income growth for households that get their income through their labor has been sluggish during this economic recovery. Profits have been strong, and the income of people who get a lot of their income from their ownership of US corporations has done well...

Consumption growth, on the other hand, has been considerably and consistently stronger. How is that possible? There are three ways. First, households have spent an ever-growing portion of their income... so much so that by 2005 the savings rate actually turned consistently negative for the very first time. Second, some American households have enjoyed strong income growth from non-labor sources. I'm referring mostly to those profits that I mentioned above. Third, many households have used mortgage equity withdrawals to finance their consumption. ... But there are good reasons to guess that all three of these supports for consumption are running out.

The end of the housing boom and concomitant MEW phenomenon has been well documented by others (yes, I'm talking about Calculated Risk), so that source of money is drying up. Corporate profits have grown amazingly well in recent years, but probably can't continue that pace for much longer.

That leaves changes in the savings rate. But if anything, it is starting to seem like we are entering a phase where households will be more interested in moving their savings rate back toward zero, rather than allow it to become more negative. However, to bring the savings rate back toward zero (not to mention positive) households will have to allow several period elapse with rates of consumption growth below the rate of income growth.

Put it all together, and it seems quite likely to me that we're in for a period of slower consumption growth. And given the importance of consumption in the US's economic growth right now, that does not spell good news for the economy as a whole.

Worries about consumption didn't stop Ben Bernanke from calling for a higher savings rate. Here's Brad DeLong with details of his comments at the press conference after yesterday's speech:

Ben Bernanke Repudiates Bush Administration Deficit-Spending Fiscal Policy: From the Wall Street Journal's Washington Wire:

Washington Wire - WSJ.com: Bernanke Advocates More Saving: Brian Blackstone reports on Bernanke’s speech in Montana.

Federal Reserve Chairman Ben Bernanke said that U.S. lawmakers should aim economic policies at boosting U.S. savings, the lack of which is the primary source of the U.S. trade deficit. “Saving is critical,” Bernanke said in response to questions after a speech at Montana Tech. He said the trade deficit isn’t a reflection of the quality of U.S. goods and services but rather a result of the fact that the U.S. invests more than it saves and the rest of the world is a “net saver.”

“That saving is sloshing around the world,” Bernanke said, and is one reason that U.S. real long-term interest rates remain “very, very low.” “We won’t always have that,” Bernanke said in reference to the high rates of foreign saving that are coming into the U.S. That’s why it’s important for the U.S. to find ways to boost domestic saving, he said.

"That the U.S. invests more than it saves" is economist-speak for (a) American households and businesses don't save very much, and (b) the government spends a honking amount more than it collects in taxes. "Aiming economic policies at boosting U.S. savings" is economist-speak for (a) raising taxes, (b) cutting government spending, and (c) encouraging households to save more.

While all of those are healthy long-run developments, in the short-run they would slow output growth and this is not the time to be pushing output downward. This is the problem with cutting taxes instead of paying off debts when times are good.

William Poole: Changing World Demographics and Trade Imbalances

William Poole has a perspective that differs from most on global imbalances and the low personal saving rate in the U.S. After briefly reviewing seven explanations for global imbalances and differences in cross-country saving rates, he concludes there's little to worry about since most of it can be explained by the life-cycle hypothesis combined with demographic differences between countries. In fact, he will argue that "to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world." I agree demographics is part of the explanation, but I'm not convinced it is as important as he has concluded, particularly if it means we become complacent about the potential for a sudden rebalancing of global accounts:

Changing World Demographics and Trade Imbalances, by William Poole, President, Federal Reserve Bank of St. Louis: ...The world economy is characterized by three highly unusual conditions. First, the capital flow into the United States from the rest of the world and accompanying rest-of-world current account surplus—the U.S. current account deficit—is very large and persistent. Second, the U.S. personal saving rate has been falling and past year became negative for the first time since 1933. Third, high-income countries are just now beginning a demographic transition in which the fraction of retired persons in the total population will rise to levels never before experienced. The idea I will explore with you is that these three conditions are connected; the first two, I believe, are to a considerable extent a consequence of the third.

Today’s topic on the connection between demographic changes and trade balances certainly is important. My analysis combines demographic and economics facts with economic theory to provide some insights into the connections between demographic changes and international trade. ... I especially want to highlight my unease with using the term “imbalances” to characterize the current situation. That term almost begs for a policy response—how can policymakers allow imbalances to persist? Unfortunately, policy responses could well involve damaging protectionist measures. I will argue that, to a large extent, the current situation is not fundamentally an imbalance but rather a condition that is conducive to coping with the major demographic changes that are occurring throughout the world...

Current Account Balances: Facts and Explanations Large and persistent current account surpluses and deficits are common in the global economy today, as illustrated in Figure 1 [note: in text links are to originals]. Since early 1998, the U.S. current account has trended downward, a fact that has attracted much attention not only in the United States but also throughout the world. As a share of U.S. GDP, the U.S. current account deficit has increased from roughly 2 percent to a level exceeding 6.5 percent in 2006. ... It is clear that today’s U.S. current account deficit substantially exceeds any other such deficits during the second half of the last century.

The United States, however, is not the only country with a current account deficit that is a relatively large share of its gross domestic product. In fact, certain European nations fit such a description. Figure 2 ... shows this ratio for the European Union and for selected European countries, some of which have current account deficits relative to GDP larger than the United States. For example, both Spain and Portugal have current account deficits that are close to 10 percent of GDP.

Are Inheritances Booming?

How much do baby-boomers stand to inherit from their parents and is it enough to make a material difference during their retirement years? Growth in the value of intergenerational asset transfer would, of course, provide additional assets that could be used in retirement, but unfortunately it looks like bequests won't provide much help to the typical household:

Boomers' big inheritance: Is it enough?, by Mark Trumbull, The Christian Science Monitor: The coming cycle of inheritances is billed as the greatest wealth transfer in US history. But don't expect it to finance the retirement of baby boomers or their children.

The reality, according to one new survey, is that when people do receive an inheritance, it's typically well under $100,000. And most people will receive no inheritance at all.

It's true that US households are richer than ever. ... But even as the pool of wealth has risen, the cost of retirement has been rising. Longer life spans, coupled with the rising cost of medical care, mean that many older Americans will use their wealth rather than pass it on to children.

"In many cases, because of increasing longevity ... it goes the other way. Instead of inheriting wealth the children wind up having to spend considerable wealth taking care of their parents," says Zvi Bodie, an expert on personal finance at Boston University. ...

Among the survey's findings:

•Only 24 percent of adult Americans expect to get an inheritance. And of those adults who have received an inheritance, the median amount received is $37,700.

•For working Americans over age 45 who have living parents, half are providing some assistance to their parents. Often it's nonfinancial – helping with chores and the like. But just as often these boomer kids are spending money on their parents.

•For workers over 45 who have grown children (over 25), one-fourth have a child living at home with them, and even more are providing financial support to those children – something most of them didn't expect to do.

The consequence: Less money is piling up in retirement funds than many workers wish. ...

This savings shortfall has gotten a good bit of media attention in recent years. But other news articles have drawn attention to a large pool of wealth that is expected to pass from older Americans – especially the World War II generation, to their offspring.

As far back as 1990, Fortune magazine talked about "the biggest intergenerational transfer of wealth in US history," in which middle-class Americans will "for the first time, inherit significant assets en masse." ...

Such reports have never promised that everyone will get an inheritance, let alone a large amount. ... America's wealth is concentrated heavily among the richest families.

"Only about 20 percent of households receive inheritances of any note," says Edward Wolff, a New York University economist who studies the distribution of wealth. "It may rise over time," he says, but "it's still going to be a minority of households." ...

Last year, an analysis done for AARP confirmed that, so far at least, boomers haven't reaped a mass windfall. Of those who have already received inheritances, the median amount as of 2004 totaled $64,000...

Shiller: Philanthropic Finance

Robert Shiller on how we might help the poor save more:

Laying a retirement lifeline for the poor, by Robert Shiller, Project Syndicate: ...Today's huge companies and the financial wizards who lead them -- or buy and sell them -- may be generous to their churches, favorite charities, and families and friends, but their professional lives are defined solely by the relentless pursuit of profits.

That perception may be largely true, but not entirely so. Consider Muhammad Yunus, who won the Nobel Peace Prize last October. His Grameen Bank ... has offered tiny loans to some of the poorest people in the world, helping to lift many borrowers out of poverty. The bank made a profit and grew over the years...

But was money Yunus' ultimate motive? In interviews, he reveals that he was actually motivated by a deep sympathy for the plight of the poor in his country. ... He tried to make a profit ... to prove the creditworthiness of these neglected people...

Paradoxically, while Yunus was pursuing profit, he was apparently not doing it for the money. ... Indeed, the history of financial institutions for low-income people is largely a history of philanthropic or idealistic movements...

China’s Huge Corporate Savings

Martin Wolf identifies the source of China's high savings rate - "huge corporate savings" - and he explains how both saving and the current account surplus can be reduced through government action:

Beijing should dip into China’s corporate bank, by Martin Wolf, Commentary, Financial Times: China represents something new in the history of the modern world: a developing country that has a vast global impact. This is why Hank Paulson, the US treasury secretary, has ... call[ed] for it to be a “responsible stakeholder”. But China will behave as the US wants only if it perceives that this is in its own interests. ...

At present, the most vexed issue between the two countries is the payments “imbalances”. Many in the US complain that China is manipulating its currency, to preserve excessive competitiveness. Certainly, China has a large current account surplus... No other country has as big a surplus.

The starting point then must be whether it makes sense for a poor country to export so much capital. The answer, I would argue, is “no”. But we must then also ask why China is running such large surpluses. ... Contrary to the conventional wisdom, the frugality of Chinese households is not the chief explanation for China’s surplus savings ..., the principal explanation is China’s huge corporate savings.

Between 2000 and 2005, ... some 70 per cent of the increase in gross savings was generated by the rising profitability of the corporate sector... Certainly, Chinese household savings are high by international standards ... an impressive 32 per cent of household disposable income in 2004. Nevertheless, household savings generate only a third of China’s overall savings. The undistributed profits of corporations are far more important. ...

Now consider the big question: does it make sense for China to save so much or, for that matter, to invest so much? After all, consumption – public and private – is no more than half of GDP, while private consumption is only 40 per cent of GDP. The answer, I suggest, is “no”. China can probably grow as fast with lower investment. It certainly does not need to accumulate more foreign assets. Higher consumption today would surely be desirable, particularly if it were consumption by – or on behalf of – the hundreds of millions of rural poor.

Moreover, as the World Bank has argued, the government has a simple way of achieving this outcome. It can ask the companies it notionally owns to pay dividends instead of keeping all the profits for themselves. Suppose it took 5 per cent of GDP from these companies in this way and spent this money on valuable social programmes: public health, for example. Other things being equal, the gross savings rate and current account surplus would fall. The welfare of the Chinese today would rise...

Now consider, instead, what might happen if gross investment were reduced, as those fearful of overheating and excessive investment suggest, but without cutting savings. Then the current account surplus would explode upwards. This would be globally disruptive and would bring no obvious benefit to China itself.

I would argue that the government needs not a policy to cut investment, but one to cut savings. Moreover, it can easily achieve this aim, because it is itself directly or indirectly responsible for the bulk of these savings. Above all, such a change is in the interest of the Chinese people. All the government needs do is exercise its rights of ownership. This, not a change in exchange-rate policy, is the most important step towards external adjustment...

An Interview with Martin Feldstein

This interview with Marty Feldstein covers its share of controversial topics. The interview is fairly long, so if you want to pick and choose the section headers are: The Art of Monetary Policy, Time Consistency in Fiscal Policy, Social Security Reform, European Social Insurance, European Union, The Return of Saving, The Economics of Health and Health Care, Executive Compensation, Supply-Side Economics, Tax Reform Panel, and The NBER:

Interview with Martin S. Feldstein, by Douglas Clement, Interview on July 10, The Region, September 2006: As a Harvard professor for nearly 40 years, Martin Feldstein has taught economics to thousands of young students, many of whom later became quite influential in their own right—as Treasury secretaries, presidential advisers, corporate leaders, even Fed governors.

As a policy adviser, he chaired the Council of Economic Advisers during the Reagan years, and landed on the cover of Time magazine in 1984 for his controversial opposition to a growing budget deficit. He has a lower profile in Washington these days but remains extremely influential, helping the current administration develop its tax cut initiatives, for instance.

And as president of the National Bureau of Economic Research, the nation's preeminent economics think tank, Feldstein has shaped the course of economic scholarship for almost three decades: identifying key issues, encouraging empirical research, creating opportunities for cooperation and disseminating working papers of leading economists long before they appear in academic journals.

But years from now it is likely that Feldstein will be best remembered as a prescient public citizen, a scholar who identified some of the most serious economic predicaments of our time, developed pragmatic solutions to those problems and then pressed policymakers—persistently—to implement them.

Social Security. Health insurance. Distortionary taxes. Unemployment insurance. The current account deficit. These are the issues that Feldstein has pushed to the forefront of popular and policy agendas decade after decade. Through a prolific stream of professional articles, newspaper columns and scholarly books, as well as frequent speeches and media interviews, he maintains a stark spotlight on crises that others try to ignore.

Educated at Harvard and then Oxford, Feldstein returned to Harvard as an assistant professor in 1967 and two years later became one of the youngest economists granted tenure by the university. In 1977, he won the John Bates Clark award as the best American economist under 40.

Numerous achievements and awards have followed, but Feldstein seems most gratified by close collaboration with colleagues. In the following interview, held during a break from the NBER's 2006 Summer Institute, a three-week gathering in Cambridge of about 1,400 economists, Feldstein notes that earlier in the day Paul Samuelson compared the Institute to Niels Bohr drawing atomic physicists to Copenhagen in the 1920s. “I thought that was a nice sentiment,” Feldstein comments quietly. His smile suggests that he could hardly conceive of higher praise.

Hi, My Name's Uncle Sam, and I'm a Debtaholic

Does the IMF have the ability to reduce the risk of a hard-landing posed by global imbalances?:

Can the IMF avert a global meltdown?, by Ken Rogoff, Project Syndicate: When world financial leaders convene in Singapore on Sept 18 for the joint World Bank/International Monetary Fund meetings, they must confront one singularly important question. Is there any way to coax the IMF's largest members, especially the United States and China, to help reduce the risks posed by the world's massive trade imbalances? ... Incredibly, the US is now soaking up roughly two-thirds of all global net saving, a situation without historical precedent.

While this borrowing binge might end smoothly, ... most world financial leaders are rightly worried... Indeed, if policymakers continue to sit on their hands, it is not hard to imagine a sharp global slowdown or even a devastating financial crisis. ...

Though the comparison is unfair, it is hard not to recall the old quip about the IMF's relative, the United Nations: When there is a dispute between two small nations, the UN steps in and the dispute disappears. When there is a dispute between a small nation and a large nation, the UN steps in and the small nation disappears. When there is a dispute between two large nations, the UN disappears.

Fortunately, the IMF is not yet in hiding, even if some big players really don't like what it has to say. The IMF's head, Rodrigo Rato of Spain, rightly insists that China, the US, Japan, Europe and the major oil exporters (now the world's biggest source of new capital) all take concrete steps towards alleviating the risk of a crisis. ...

[S]uch steps might include more exchange-rate flexibility in China, and ... a promise from the US to show greater commitment to fiscal restraint. Oil exporters could, in turn, promise to increase domestic consumption expenditure, which would boost imports.

Likewise, post-deflation Japan could promise never again to resort to massive intervention to stop its currency from appreciating. Europe, for its part, could agree not to shoot its recovery in the foot with ill-timed new taxes such as those that Germany is currently contemplating.

Will the IMF be successful in brokering a deal? The recent catastrophic collapse of global trade talks is not an encouraging harbinger. ... Fortunately for Mr Rato, addressing the global imbalances can be a win-win situation. The same proposed policies for closing global trade imbalances also, by and large, help address each country's domestic economic concerns.

For example, China needs a stronger exchange rate to help curb manic investment in its export sector, and thereby reduce the odds of a 1990s-style collapse. As for the US, a sharp hike in energy taxes on gasoline and other fossil fuels would not only help improve the government's balance sheet, but it would also be a way to start addressing global warming. What better way for new US Treasury Secretary Hank Paulson, a card-carrying environmentalist, to make a dramatic entrance onto the world policy stage? ...

If today's epic US borrowing does end in tears _ and if world leaders fail to help the IMF get the job done _ history will not treat them kindly. Instead, they will be blamed for not seeing an impending catastrophe that was staring them in the face.

Let's hope that on this occasion in international diplomacy, the only thing that disappears are the massive global trade imbalances, and not the leaders and institutions that are supposed to deal with them.

Interventions don't usually work. Those with addictions don't usually seek help until they "hit bottom." You can give them advice, explain rationally why they must change, and they may even nod their head and agree with you at some level. But until a crisis forces them to reconsider their ways, they will not hear the message and they will not take actions to forestall the hard-landing they are likely to have.

The IMF can keep nagging, but it's up to the countries involved to become serious about reform. While I hope that countries can be more rational in their approach than addicted individuals and avoid hitting bottom before reforming, so far it's difficult to detect a serious effort to address the underlying problems.

A Mystery

Nobody knows how many workers have accepted lower pay and benefits to keep their jobs:

Here, Take Back Some of My Pay, It’s Too Much, by Louis Uchitelle, NY Times: A number is missing. No one knows how many American workers have agreed to accept, however reluctantly, a cut in their wages or benefits or both in recent years.

The government tracks unemployment, job creation, layoffs, hours worked, average hourly pay and various other aspects of employment. But it doesn’t add up the number of people who have forfeited big chunks of their pay and benefits, and neither do unions or academic researchers.

That was true of layoffs until the early 1980’s, when the Rust Belt experience, and the devastating loss of blue-collar factory jobs, became a political issue. Congress, in response, asked the Bureau of Labor Statistics to count the layoffs in national surveys. ...

Keeping a job, but losing 15 or 20 percent of a salary and most of a pension, is a painful experience — and certainly not good for consumer spending. Still, there has not been enough political pressure for an accurate count of those affected. That is partly because many workers and unions have agreed to the concessions to preserve jobs.

Is there a ballpark number? Piecing together union data shows that it is probably above two million people in this decade alone. But no one knows. ... “None of our earnings surveys show these concessions,” said Thomas L. Nardone, an assistant commissioner at the Bureau of Labor Statistics. “We just don’t track that number.”

That would be useful to know. This is one of a series of short articles:

[F]ive New York Times reporters each set out to find one statistic, often overlooked, that said something important about the economic health of the American worker

Here's another entry on debt accumulation in recent years:

Borrowers We Be By, by Steven Greenhouse, NY Times: With their raises often lower than the inflation rate, millions of Americans have embraced the same strategy to maintain their living standards — borrowing and then borrowing some more.

As a result, debt payments now consume 19.4 percent of the income of the average American family, and 23 percent of the families in the bottom two-fifths of families by income devote at least 40 percent of their income to debt payments. With debt burdens so high, some economists fear a new wave of foreclosure and personal bankruptcies now that interest rates have climbed. ...

Household debt rose to 132 percent of disposable income last year, partly because many Americans have pushed their credit card debt to the max and because many, including many high-income Americans, have piled on the mortgage debt. Last year, for the first time since the Depression, the personal savings rate for the nation fell below zero, meaning that Americans are spending more than they are earning (and are saving no money on a net basis).

“There are really two types of households out there,” Mr. Zandi said. “High-income households have balance sheets about as good as I’ve ever seen, while lower-income households have balance sheets about as bad as I’ve ever seen them — complete tatters. These households are on the financial edge, and if there’s any slight disruption, like a car breaking down, it can be a real disaster for them financially.”

The Difference in Saving Rates between China and the U.S.

Robert Shiller explains the difference in saving rates between China and the U.S.:

Growth rate gulf result of opposite approach to saving, by Robert Shiller, Project Syndicate: The saving rate in China is the highest of any major country. China's gross saving rate ..., which includes both public and private saving, is around 50 percent.

By contrast, the saving rate in the United States is the lowest of any major country - roughly 10 percent of GDP. Differences in saving rates must be a major reason that China's annual economic growth rate is a full six percentage points higher than in the US. ... Unfortunately, explaining saving rates is not an exact science.

Ingrained habits probably explain more about China's saving rate. When incomes are growing rapidly, as they are in China, it is easier to save because people are not yet accustomed to a higher standard of living. They also tolerate enterprise or government policies that encourage high saving.

You Are Pre-Approved

According to the Fed, all those credit offers we get in the mail are good for us:

Love That Junk Mail, Washington Wire, by Christopher Conkey: Think most people hate all those pre-approved offers for credit that jam your mailbox every week? Think again.

The Federal Reserve Monday released results from consumer surveys it undertook in 2004 and 2005, and one of the more interesting findings relates to the way people view pre-approved credit offers. While more than half of cardholders said they receive six or more offers a week, and less than half of the people receiving such solicitations actually open them, more than 70% of cardholders said the government should not outlaw pre-approved offers. ...

The authors of the Fed report say there’s a good reason for this: All those annoying, mailbox-clogging offers are actually good for us. The “prevalence of prescreened solicitations is useful in disseminating pricing information and encouraging competitive conditions in markets for credit cards generally, even if only a small minority of recipients actually responds,” the report said.

The authors also found evidence of an “other guy effect”...: 85% said they think pre-approved offers cause other people to use more credit, but only 15% admitted doing so themselves.

I wonder if the U.S. government gets offers in the mail from Asian and oil producing countries telling them they are pre-approved for billions and billions more in credit. More seriously, I wonder to what extent the knowledge that credit is available quickly if and when you need it through the internet, pre-approved mail offers, or other means has reduced precautionary and other types of saving.

The Savings Glut

Was there and is there still a savings glut? Ben Bernanke thinks so. This is from David Altig at macroblog:

macroblog: The Chairman Speaks: The Savings Glut Persists: More from Chairman Bernanke's exchange with Senator Bennett during yesterday's testimony:

BENNETT: Do you still believe there's a global savings glut and that we can expect people to continue to want to put their money here?

BERNANKE: I think there still is a global savings glut. It may have moderated somewhat because of increased growth in some of our trading partners. But on the other hand, there's also been, of course, these large revenues that the oil producers are accumulating because of the high price of oil. They are not able to absorb - - use those revenues at home very quickly. So they are taking that money and putting it back into the global financial system. And so that's contributing to this overall global savings glut...

So I think there has been some change, but the broad idea that the global savings glut is out there I think is still valid.

Of what Mr. Bernanke speaks, in pictures:

Still looking pretty gluttish.  The data, if you are interested:

Download savings_glut.ppt

UPDATE: Shame on me.  I should have added this part of the discussion:

BENNETT: So you're suggesting that foreign investment in the United States is not about to dry up at any point soon?

BERNANKE: I don't think it's going to dry up. I do think that over a period of time we should become more reliant on our own saving and reduce the current account deficit.

Emphasis added.

Like the word bubble, glut has a new meaning. To me, the term glut conveys a disequilibrium condition -- a time when aggregate demand is deficient, there is involuntary unemployment, goods are piling up on store shelves (that's the glut, lots of goods, nobody to buy them), and for some reason prices aren't moving to clear the market (e.g. the Malthus-Say debate where Malthus said, essentially, that gluts are caused by high profits leading to excessive capital accumulation and a mismatch between saving and investment; Say responded by saying that gluts were impossible because supply creates its own demand, i.e. with Say's law).

So every time I hear savings glut I have to remind myself of how the term is being used. I don't think Bernanke means that the supply of savings exceeds the demand for savings at the current interest rate even though I'm certain he is well aware of this interpretation of a glut. He means increases in supply are holding interest rates down as they move to clear the market. Thus, a glut simply means a large supply driving down equilibrium prices, not a disequilibrium condition where supply exceeds demand.

A Nickel Saved Through Opt-Out and Matching Grants is a Nickel the Government Won't Have to Give You

Having used Hal Varian's little blue book as one of my micro texts in graduate school, I have no doubt about his skills as a microeconomist. My complaint about this article examining policies to encourage low-income Americans to save more is that those skills are not used to identify the market failure the policies address.

To say, as in the opening line, that "Economists are in almost universal agreement that Americans save too little," and to follow with suggestions that the government intervene in the marketplace implies these markets do not produce the right incentives to save, that the market outcome is one of too little saving. The article does mention different savings rates as an explanation for differences in asset accumulation over time, but that is a behavioral statement, not a specific market failure. If we don't know what the problem is, how will we know what solution is best? My preference is to start by identifying the problem, then proceeding to find a solution. But whatever the problem is, the argument Varian makes is that these programs appear to work:

Looking for the Incentives That Will Prompt Americans to Save More, by Hal Varian, Economic Scene, NY Times: Economists are in almost universal agreement that Americans save too little, and several policies have been proposed with the goal of encouraging them to save more.

The Bush administration favors increasing contribution limits on tax-deferred savings accounts like I.R.A.'s. Critics argue that there would be little impact on total savings ... since wealthy households would simply transfer assets from taxable accounts to tax-sheltered accounts.

Leaving aside the behavior of high-income households, responsible members of both parties recognize that providing better incentives to low-income people is the most challenging problem. How can we get this group to save more?

It is possible for low- and middle-income groups to increase savings. After a detailed examination of the financial circumstances of people close to retirement, two economists, Stephen F. Venti ... and David A. Wise ..., concluded that the primary reason for differences in retirement assets was differences in propensities to save. ...

One promising proposal has been to set ... 401(k) plans so that employees are automatically enrolled in an appropriate plan unless they explicitly choose otherwise. ...[T]his simple policy increases participation rates dramatically.

Another suggestion is to provide matching grants to low-income individuals. ...("Saving Incentives for Low- and Middle-Income Families: Evidence From a Field Experiment With H&R Block"; ... nontechnical summary ...) In this experiment, ... low- and middle-income families ... were offered a 20 percent match on their contributions to an I.R.A., a 50 percent match or no match at all...

Only 3 percent of the individuals who had no match — the control group — contributed to an I.R.A. But 8 percent of those with a 20 percent match rate contributed, and 14 percent of those with a 50 percent match contributed. The amount contributed was four times as much as the control group for the 20 percent match rate and seven times as much for the 50 percent match rate. ... And most people stuck with their plans: four months after the initial contribution, over 90 percent of the individuals still kept the money in their I.R.A.'s.

These effects are far larger than those of the Saver's Credit, an existing program that provides a tax credit based on the amount of tax-deferred savings. The problem is that a tax credit is useful only if you pay taxes, and many low-income individuals have little or no tax liability after other deductions and credits are applied. Furthermore, the Saver's Credit is complicated and hard to understand. A matching contribution to a savings program is much easier to comprehend. ...

As the authors put it, "Taken together, our results suggest that the combination of a clear and understandable match for saving, easily accessible savings vehicles, the opportunity to use part of an income tax refund to save, and professional assistance could generate a significant increase in contributions to retirement accounts, including among middle- and low-income households."

Matching grants also have a long and venerable history as an American institution. They were invented by none other than Benjamin Franklin in conjunction with his fund-raising efforts for the Pennsylvania Hospital, the first public hospital in America, established in 1751.

Franklin persuaded the legislature to participate by indicating that it would receive "the credit of being charitable without the expense" and explained to the donors that "every man's contribution would be doubled." No doubt the sage of Philadelphia would heartily approve of his innovation being used to encourage the virtue of thrift.

Consumer Debt

These writers from Fred Alger Management argue that the current level of consumer debt is not a problem:

Alive and well under a mountain of debt, by Zachary Karabelland and Dan Chung, Commentary, Financial Times: Remember the scene in Monty Python and the Holy Grail where two men push a wheelbarrow through a plague-afflicted village shouting: “Bring out your dead”? A family heaves a body on to the pile, whereupon it lifts his head and says: “But I’m not dead yet!” One man whacks him with a cudgel and says: “Now you are.” That is the perfect metaphor for the American consumer on the one hand and strategists, commentators and economists on the other. They keep trying to bury the consumer under a mountain of debt, even though he is alive and kicking.

There is an understandable cultural prejudice against debt. For most of history, the risks outweighed the costs. If you calculated wrongly, you did not just go bankrupt: you lost your business, home and possessions. ... Low interest rates, securitisation and bankruptcy law have changed the nature of debt.

Our prejudice against debt no longer makes sense. In March, Federal Reserve chairman Ben Bernanke said as much when he suggested that the substitution of mortgage debt for credit card and automobile debt had been a rational decision by consumers to shift leverage into lower-rate obligations. But his assessment is at odds with attitudes on Main Street and Wall Street, especially in light of global agitation over inflation and excess liquidity.

There is no denying that the absolute amount of consumer debt is higher than ever. ...  a total of $11,500bn. Big numbers, yes, and big numbers are easily turned into a harbinger of crisis. But take the financial net worth of US households (which excludes the value of homes): $26,500bn, an all-time high. With home value included, that rises to $52,000bn – more than four-and-a-half times household debt. ...

Even with the Fed tightening, the absolute level of rates is low by historical standards, so low that for all the refinancing and home-equity extraction we have seen, we can still see more. The average mortgage rate for a 15-year loan is around 6 per cent. In 2000, it was 7.72 per cent. Even though conventional wisdom says that consumers are tapped out, they can continue to use their homes as piggy banks. Even if rates go up another 50 basis points, it is likely that consumers will extract hundreds of billions of dollars in cash-out refinancing this year.

Furthermore, the amount that households must spend to service their debts is manageable. That should be the central concern: not how much debt, but whether it is affordable. In 2001, households spent 12.9 per cent of income to service their debts; by the end of 2005, that had risen to nearly 14 per cent. Again, the key issue is rates: if rates are at or near a peak, debt-financed spending can continue. If not, we will face a credit crunch, especially since average incomes are barely rising.

Anyone who defends current [debt] levels risks being labelled as blind not only to structural imbalances but to the struggles faced by families who are taking on debt to meet basic obligations such as homes, medical costs and education. We are not making a judgment about the wisdom of individual consumers, about the struggles they face or about an American culture that overemphasises consumption and encourages excessive spending. We are making a structural argument that the economy can sustain far higher levels of consumer debt than in the past. Even if more individuals face a credit squeeze, the system overall is in no jeopardy.

In addition, many consumers may be using debt more wisely than commentators give them credit for. The increasing array of financial instruments means that people can take on more debt when they are young and their career outlooks are improving. ...

Stripped of its stigma, debt is a neutral tool. Used prudently, it generates economic activity; taken on foolishly, it is a recipe for problems. The question is: what is the tipping point? Prudence, say the sceptics, dictates cutting back now. But is that prudence, or fear? ...

In a world of low rates and less structural risk, the definition of moderation – and risk – must change. The fear debt arouses once protected people from stupid decisions, but today it impedes a rational assessment of costs and benefits. ...

Recent evidence indicates:

"On average, debt burdens appear to be at manageable levels, and delinquency rates on consumer loans and home mortgages have been low," Mr. Bernanke said...

While consumers are managing their finances fairly well so far, I am not as willing as the authors to declare household debt a worry free zone, particularly in the event of a sudden downturn in the economy.

"I'd Gladly Pay You Tuesday for a Hamburger Today"

Are we being Wimpy when we worry about household and government debt? This post looks at U.S. indebtedness today and some of the associated risks, and the post that follows examines how attitudes toward debt have changed over time:

Reasons to Worry, by Niall Ferguson, NY Times Magazine: ...[A] question for economists is whether the United States is capable of evolving out of its present excessive indebtedness. Or could the global economic environment change so drastically as to threaten ... decline relative to smaller, more dynamic economies?...

Since becoming president, George Bush has presided over one of the steepest ... rises ever in the federal debt. The gross federal debt now exceeds $8.3 trillion. There are three reasons for the post-2000 increase: reduced revenue during the 2001 recession, generous tax cuts for higher income groups and increased expenditures not only on warfare abroad but also on welfare at home. And if projections from the Congressional Budget Office turn out to be correct, we are just a decade away from a $12.8 trillion debt — more than double what it was when Bush took office.

Big public debts are not always bad, to be sure. It could be argued that in his first term Bush wisely used fiscal policy to boost aggregate demand and counter the impact of the dot-com bust. Public borrowing also allows "tax smoothing" by spreading out over time the cost of big one-off expenses like wars, three of which the United States has fought since 1999.

On the other hand, by requiring larger interest payments, big public debts devour revenue that could be spent on other programs. They may crowd out private investment by pushing up long-term interest rates. They may also have a regressive distributional impact, transferring economic resources from taxpayers to bondholders or from future generations to the present generation. ...

Was There a Golden Age of Thrift?

Does the high indebtedness of households signal a moral decline relative to previous generations? Not according to this look at how consumer indebtedness has changed over time:

The American Way of Debt, by Jackson Lears, NY Times: Americans are awash in red ink. Consumer indebtedness is soaring, the savings rate is down to zero and people are filing for bankruptcy at record rates. To many observers, these are symptoms of cultural decline, from sturdy thrift to flabby self-gratification...

The equation of debt and decline assumes that once upon a time Americans lived within their means and saved for what they bought. This is fantasy: there never was a golden age of thrift. Debt has always played an important role in Americans' lives — not merely as a means of instant gratification but also as a strategy for survival and a tool for economic advance.

Yet our moral traditions have concealed this complexity. "Owe no man anything," St. Paul warned... Indebtedness signified a sin against the Protestant ethic of self-control; it also threatened the ideal of independent manhood that underwrote the founders' vision... The indebted man "must smile on those he hates, he must extend his hand where he would strike, he must speak pleasantly with a curse in his throat," a Harper's contributor wrote in 1894. "He wears dependence like a yoke." Benjamin Franklin coined similar lessons..: "The Borrower Is a Slave to the Lender." "Be frugal and free." The link with lost freedom was more than metaphorical: you could still be imprisoned for debt in many places (including New York City) down to the early 1900's.

Still, the case against debt was more principled than practical. Every generation of moralists imagined the same fall... In their novel "The Gilded Age" (1873), Mark Twain and Charles Dudley Warner mourned the disappearance of the antebellum "horror of debt"...  In 1924, the editor of The Saturday Evening Post complained that "the firmly rooted aversion to debt ... has almost completely evaporated." In 1958, John Kenneth Galbraith noticed that "there has been an inexplicable but very real retreat from the Puritan canon that required an individual to save first and enjoy later."

In fact, debt is as American as cherry pie. ... Among ... rural folk, through most of the 19th century, cash was scarce, and country-store ledgers carried local peoples' debts for years, sometimes forever. Factory workers and laborers used debt to make ends meet, resorting to pawnshops, loan sharks, relatives and friends. Even moralists admitted distinctions between good ("productive") debt and bad ("consumptive") debt. ...

After 1900, the proliferation of mass-marketed products encouraged a more open tolerance for consumer debt. By the 1920's, millions of middle-class Americans bought durable goods on time payments — sewing machines, washing machines, radios, automobiles, houses. Lenders acquired legitimacy...

Indebtedness could discipline workers, keeping them at routinized jobs in factories and offices, graying but in harness, meeting payments regularly. Good consumers would be good producers. The economist who proposed this idea was Simon Nelson Patten, in "The New Basis of Civilization" (1907). ... He predicted that workers' desires for things would not undermine their capacity for disciplined achievement, as generations of moralists had claimed...

Patten was onto something. The disciplining power of debt was undeniable. Even during the Depression, while Americans cut back on new borrowing, they also denied themselves food and clothing to avoid repossession of refrigerators or real estate. ... In 1932, a Harper's contributor observed that the middle-class homeowner "no longer has possessions but only obligations." This homeowner did not exactly represent an ethos of self-gratification.

The true fulfillment of Patten's vision depended on an economically secure working population. These conditions awaited the rise of strong industrial unions and the comparative prosperity of the post-World War II era. The acquisition of appliances, cars and houses was often financed on the installment plan or with the assistance of government agencies like the Federal Housing Administration. Thanks largely to union power, more fortunate workers could depend on steady wages that allowed them to pay off big-ticket items over time. Patten would have been pleased.

The upward spiral of earning and spending survived until the 1970's, when the midcentury ideal of corporate citizenship evaporated in the harsher climate of renewed international competition. Fearing foreign rivals, American business ended its implicit social contract with unions by seeking cheap labor in overseas markets.

During the 1980's, ... Reagan's rhetorical refusal of limits combined with the deregulation of the lending industry to detach dreams of luxury from previous constraints. As money worship mounted, job security disappeared and inequalities widened, pundits spoke of a new Gilded Age.

By the 1990's, bloated icons of affluence proliferated: the gargantuan pseudo-military vehicle, the 10,000-square-foot hacienda. A bigger standard package of household goods demanded deeper debt and accelerated the pace of the consumer treadmill. No one wanted to look like a "loser."

But for many borrowers, debt has not been just about keeping up appearances. Less-affluent Americans have resorted to borrowing for groceries as well as cars. Public policies have intensified their plight. The freezing of the minimum wage, the tightening of unemployment insurance and workmen's compensation programs, the shifting of the tax burden from the rich to the rest — these changes have starved public services while leaving ordinary Americans more dependent than ever on debt. One of the most consistent statistical findings of recent years is that about half of all personal bankruptcies have been caused by medical bills. Whatever else our current indebtedness may signify, it is hardly a riot of hedonism.

Hitting It Big for Retirement

Given the amount of tax revenue that states raise regressively through legalized gambling such as lotteries and video poker, I thought this was an interesting table. It compares the expected earnings in constant dollars from investing various amounts in an S&P 500 index fund versus using the money to play the lottery. The reason for looking at this is that, according to the Tax Foundation article:

A recent survey conducted by Opinion Research Corporation ... and ... reported in a MarketWatch article, found that Americans are, for the most part, pessimistic about their ability to save for retirement—so pessimistic, in fact, that 21 percent of respondents said playing the lottery is “the most practical strategy for accumulating several hundred thousand dollars” for retirement.

The MarketWatch article continues saying "...with 38% of those who earn less than $25,000 pointing to the lottery as a solution." This table looks at the expected losses from pursuing such a strategy over a 40 year time period:

Table 1. Rate of Return on Lottery vs. Rate of Return on Stocks over a Forty-Year Period in 2006 Dollars

Average Amount Spent or Invested per Month	Total Spent or Invested over 40 Years	Expected. Return from Lottery(a)	Expected Return from S&P 500	Increased Retirement Savings from Investing Rather than Playing Lottery
$1	$761.37	$178.14	$1,622.17	$1,444.03
$5	$3,806.85	$890.72	$8,110.85	$7,220.13
$10	$7,613.70	$1,781.44	$16,221.69	$14,440.26
$25	$19,034.26	$4,453.59	$40,554.23	$36,100.64
$50	$38,068.52	$8,907.18	$81,108.46	$72,201.29
$100	$76,137.03	$17,814.35	$162,216.92	$144,402.57
$150	$114,205.55	$26,721.53	$243,325.39	$216,603.86
$200	$152,274.07	$35,628.70	$324,433.85	$288,805.14
$250	$190,342.59	$44,535.88	$405,542.31	$361,006.43
$300	$228,411.10	$53,443.05	$486,650.77	$433,207.72

Note: Calculations assume a constant 2 percent inflation rate, 7 percent return on S&P 500 average, and monthly compounding. Lottery spending is not adjusted for life cycle or income cycle.
(a) Based on a 53% cumulative payout rate for all lotteries from 1964 through 2003. ... [Source: Tax Foundation]

Interesting difference in expected returns, but I'm not convinced that people would invest much more if lotteries and other forms of legalized gambling did not exist. The more important concern is, of course, the highly regressive nature of this form of "voluntary" taxation that provides false hope for those in dire economic conditions. Lotteries are easy politically, but they impose large and inequitable costs on some segments of the population. The state should get out of the gambling business and raise taxes by some other means. Nobody has to pay a dollar more and no services have to be cut, just levy the taxes directly so that the tax burden is clear rather than having it obscured through lotteries and other devices.

Interest Rates and Saving

Martin Feldstein says:

The Federal Reserve has reversed its low interest rate policy... It will only be a matter of time until the household saving rate is at least back to the 2.4 per cent level of 2002.

I was curious about this so I plotted the 3-month T-Bill rate against the personal saving rate since 1980 to get a rough idea of the association between the two variables:

Click to enlarge

High Household Saving in China

In China, factors such as underdeveloped financial markets and fear of large future expenditures due to both economic insecurity and expected inflation cause households to accumulate large savings balances:

High prices are eroding consumer confidence, by Zhang Shunyi, Shanghai Daily: Mounting household savings in China's banks is not necessarily the good thing it seems. According to the People's Bank of China, domestic individual bank deposits... hit 14 trillion yuan (US$1.72 trillion) by the end of 2005. The record-breaking amount of deposits indicates that the Chinese people are much wealthier on the whole. However, rapid accumulation of deposits also shows that people are reluctant to spend as the consumption rate has been on the decline for five consecutive years...

Last year, loans issued by China's banks only accounted for 53 percent of the total money they collected. Part of the other 47 percent was stored in the PBOC as the excess reserve. To make a comparison, loans took up 91 percent of the total a decade ago... Basically, there are two ways to deal with the problem of excessive household savings. One is to further encourage consumer spending thus reduce the deposits. The other, as was mentioned above, is to find more channels, which are profitable and safe, to digest the deposits. Easier said than done.

Both of these two measures require fundamental adjustments in the system of social and banking mechanism. The importance of results brought by these changes can never be understated - it links directly with economic stability. Why are people reluctant to spend? Chinese people are well-known for the habit of hoarding up valuable things. But under the current climate, worry about high prices is perhaps the most cited reason.

"What many people see is the rising price of seeing a doctor or studying in a good school. That makes them feel less safe," said Sun Lijian, a professor at Fudan University's School of Economics. According to a recent survey from Horizon Research, expensive medical services and changes in the pension scheme are listed among the top concerns that trouble Chinese people. If people lose their job, suddenly become ill, want to buy an apartment or hope to deliver better education to their kids, they have to splash out a great deal of money on those things.

The housing price provides a case in point. Even in second-tier cities such as Hangzhou, Wenzhou or Ningbo, people have to save their disposable income for 27 years to buy an 80-square-meter apartment on average. And compared with 1999, the cost of fees for a college student has jumped from 51,000 yuan to 131,000 yuan...

Reducing interest rates to induce people to spend money is difficult. "The PBOC is very prudent about making any more changes to the interest rate. It is nearly impossible to reduce the rate when it already stands at such low a level," said Wu. Perhaps the most important thing to do is to give people confidence about their basic life.

In addition to the measures to enhance economic security, it is also important to develop the financial services industry so that it doesn't take decades of saving to, for example, buy an apartment. In order to reduce its dependence on exports and aid in global rebalancing, China must increase domestic consumption. The "fundamental adjustments in the system of social and banking mechanism" won't happen overnight supporting Bernanke's view that it could be as long as ten years before imbalances are resolved.

The Bigger the Oil Price Shock, the Harder We'll Fall

Martin Feldstein is worried that if oil prices go up again and depress economic activity, a falling saving rate won't to bail us out this time:

America will fall harder if oil prices rise, by Martin Feldstein, Commentary, Financial Times: The price of imported oil in the US doubled between summer 2003 and summer 2005, reducing consumers’ purchasing power by more than 1 per cent of gross domestic product. Nevertheless, the economic slowdown that was widely expected never occurred. Consumers kept spending and businesses kept investing. ... The continued strong growth contrasts sharply with the economic weakness that occurred after almost every previous significant rise in the oil price. How do we explain this remarkable difference? And what are the implications for the likely response to a future rise in oil prices?

The key to the economy’s strength in 2004 and 2005 was that household saving declined dramatically while the price of oil rose. ... This shift ...in the annual rate of saving far outstripped the fall in income caused by the higher cost of oil. This fall in saving allowed households to raise consumption spending on non-oil goods and services while paying for the higher cost of imported oil. The primary cause of this dramatic shift was the fall in interest rates and the resulting rise in mortgage refinancing. Homeowners who refinanced their mortgages took out cash and reduced their monthly payments at the same time. Much of the cash obtained by refinancing was spent on consumer durables, home improvements and the like. The lower monthly payments permitted a higher level of sustained spending on all non-durable categories. ...

The faster increase in consumer spending caused businesses to invest more and raised the rate of growth of GDP. Faster GDP growth caused an accelerated rise in employment and a fall in the rate of unemployment. Mortgage interest rates were falling because the Federal Reserve’s fear of deflation had caused it to lower the short-term federal funds rate ... to the extremely low level of 1.0 per cent in 2003 and to leave it there in the first half of 2004 before beginning a very gradual process of rate increases. ... The lower mortgage rates induced refinancing and the subsequent gradual rise in rates induced additional refinancing by homeowners who wanted to borrow before rates rose further.

The powerful effect of mortgage refinancing on consumer spending was a very happy coincidence for the American economy at a time when oil prices were depressing consumers’ real incomes. If oil prices were to rise again in 2006 or 2007, the adverse effect on consumers’ real incomes would not be offset by increased mortgage refinancing. Mortgage refinancing has now peaked and is declining. The Federal Reserve is raising interest rates again to counter the inflationary pressures that remain from the rise in energy costs. And individuals no longer have the large amounts of household equity against which to borrow.

A rise in the oil price could happen again at any time. There is little spare capacity in global oil production and oil demand is rising rapidly in China and other Asian countries. A shock that reduced the production or shipping of oil could drive its price sharply higher. Speculative forces could compound this problem. The US was lucky after 2003 to escape the contractionary effect of an oil price rise even without an explicit change in monetary or fiscal policy. It would not be so lucky if a big oil price increase happened again now.

I don't always agree with Feldstein, but I do here.

Impatience and Savings

I haven't followed this literature closely, but it looks interesting and many of the papers noted below have been posted here ( 1, 2, and 3, the last has links to seven papers). It's an analysis of savings behavior starting from a biological perspective. On another note, I'm very literally off to grandma's house in a few minutes - lots of rivers to pass over and lots of woods to pass through - so I won't be able to post or comment until tonight:

Impatience and Savings, NBER Reporter: Research Summary Fall 2005, by David Laibson: When making decisions with immediate consequences, economic actors typically display a high degree of impatience. Consumers choose immediate pleasures instead of waiting a few days for much larger rewards. Consumers want "instant gratification." However, people do not behave impatiently when they make decisions for the future. Few people plan to break their diets next week. Instead, people tend to splurge today and vow to exercise/diet/save tomorrow. From today's viewpoint, people prefer to act impatiently right now but to act patiently later.

Data from neuroscience experiments provide a potential explanation for these observations: short-run decisions engage different brain systems from long-run decisions. Using functional magnetic resonance imaging (fMRI), Samuel McClure, George Loewenstein, Jonathan D. Cohen, and I have shown that decisions that involve at least some short-run tradeoffs recruit both analytic and emotional brain systems, whereas decisions that only involve long-run tradeoffs primarily recruit analytic brain systems. These findings suggest that people pursue instant gratification because the emotional brain system - the limbic system - values immediate rewards but only weakly responds to delayed rewards.

"The Rabbit is Indeed in the Middle of the Python"

The theme of the next few posts is global imbalances, so let's start things off with two articles about China. First, The Financial Times wonders if China's rapidly aging population will cause slower economic growth in the future:

Why China stands to grow old before it gets rich, by David Willetts, Commentary, Financial Times: ...One reason for China’s stellar growth is that it is at a demographic sweet-spot. The massive reduction in infant mortality achieved by China’s barefoot doctors in the 1960s and 1970s is now yielding a surge of young workers – an extra 10m working-age adults per year. China’s challenge now is just to absorb them into the labour force. ... There are few pensioners and there are not many children either. The rabbit is indeed in the middle of the python. As early as 2015, China’s working age population will actually start falling. By 2040, today’s young workers will be pensioners – in fact the world’s second largest population, after India, will be Chinese pensioners. ... The desperate rush for economic growth is fuelled by fears that China could grow old before it grows rich. ... Imposing the one-child policy ... is having an extraordinary effect. If you can have only one child it becomes highly desirable to have a boy. The rule is not as strictly enforced as it was, but you can now see its effect on the second child, which in the eyes of many Chinese really is the last chance to have a boy. For every 100 female second children, there are 152 males. Overall, there are now about 120 boys for every 100 girls in China. ... China is going to have to attract large-scale female immigration or many of its young men will leave. ... So China is going to be full of old people and rather earnest, frustrated young men. It will be one of the most dramatic and unusual demographic changes the world will have seen for a very long time, and Chinese leaders now would do well to plan for such a future.

Next The Los Angeles Times discusses how economic insecurity, lack of an effective social security system, underdeveloped financial and mortgage markets, and high educational costs cause the high savings rate in China:

Anxiety Drives Chinese Fixation on Frugality, by Don Lee, LA Times: ...China's economic reforms have vastly improved living standards, but the last two decades also have seen a dismantling of the socialist "iron rice bowl" that provided basic health and welfare from cradle to grave. The result is that many Chinese today feel more insecure about their future than their parents' generation did. Chinese families are saving about half of their income. ... [M]ost experts expect China's savings rate to stay high for years to come because of the need to prepare for a large dependent elderly population. ... China, like other nations in East Asia, has a long tradition of thrift. Analysts say it may be linked to Confucian values that encourage thrift and production rather than consumption. China's propensity to save also reflects its agrarian society, where people face more risks of fluctuating incomes and their long work hours leave them with little leisure time to consume. ... pensions, for those who have them, tend to be modest. China's healthcare system is broken; insurance is inadequate for most everybody. Many employers in China don't provide insurance ... In the event of a serious ailment, ... "even an entire life savings may not be enough. So they dare not spend." Zhuo Yunbao recently had a scare when his father was hospitalized with a stroke. He says his father may need a pacemaker, but that's not covered by the state insurance for the elderly. The family is saving for more than a rainy day. They want to buy a car. A few years from now, Zhuo says, maybe they'll look at moving into a bigger home. ... More than anything else, though, the Zhuos are squirreling away for their son's education. ... Like many young Chinese parents, the Zhuos want to send their son abroad for college. They have their sights on England or the U.S., where four years of tuition could reach $125,000. The family has saved a little more than 10% of that. "We have a long way to go," Zhuo says.

Guy de Jonquières: Asia's Missing Investment

Asia has plenty of saving. So why is investment so low?   For Guy de Jonquirères, the answer lies with excessive regulation and weak competition:

Asia’s missing investment, by Guy de Jonquières, Financial Times: International investors ... cannot get enough of the great Asian growth story. ... Yet Asian companies appear curiously reticent about joining the party. Eight years after Asia’s financial crisis and with solid growth forecast ... one would expect businesses to be making big capital outlays ... However, with the exception of China, they have not done so. ... Whatever the reason for the caution, it is not lack of funds. ... private sector saving..., according to the latest available data, is higher than before the crisis. ... Some critics blame Asia for generating excessive current account surpluses by saving too much. However, the International Monetary Fund argues in a recent report that the real culprit is an “investment drought”(Asia Pacific Regional Outlook, September 2005). ...[Why have] they ... held back. ... One reason could be the shift of manufacturing to China ... However, studies have found little evidence that China has diverted foreign direct investment away from its neighbours. Another theory is that official data exaggerate companies’ financial strength by ignoring many smaller ones that are still struggling ... Equally, an overhang of unsold property, built before the crisis, may have delayed a recovery in construction. But not all countries experienced property bubbles during the 1990s. Finally, business confidence may have been dampened since the crisis by setbacks such as the severe acute respiratory syndrome scare, the 2001 US growth slowdown and cyclical downturns in the global electronics industry. But all this is conjecture. The IMF confesses it is puzzled. Private economists are also stumped.

Most, nonetheless, still believe investment will recover. There are some positive signs. ... But more investment is not necessarily better: witness China’s vast glut of manufacturing capacity. If the rest of Asia simply reverts to its old habit of investing for export-led growth, it will further depress product prices and fuel western protectionism. To be sustainable, its growth must be based on stronger domestic demand. But ... except in China and India, households are already saving less and borrowing more, so cannot be expected to boost consumption much further. As for governments, ... their finances allow only limited room prudently to increase spending. There is another option. Much of Asia is crying out for better transport, healthcare, education, power and water. The World Bank and the Asian Development Bank say $1,000bn needs to be spent on infrastructure. Governments cannot provide it all. But more imaginative approaches to privatisation could help fill the gap and create new opportunities for private investment. They might also reduce scope for corruption ... Second, there is huge untapped potential to boost wealth creation by stimulating domestic markets. The prime candidates are services, which in much of Asia are shackled by weak competition and over-regulation. Setting them free would yield big productivity and efficiency gains....[S]uch reforms will be essential ... if Asia is to keep growing. Its past development has relied heavily on harnessing abundant cheap labour and capital to producing for export markets. ... How Asia solves its investment puzzle will be critical to shaping its future development. When the region’s next investment wave arrives, it should be judged not just by its weight but by its quality.

While excessive government regulation and intervention is certainly to be avoided, I think there is more to recovery from the investment drought than "imaginative approaches to privatisation" and "Setting them free." For those interested in more on this issue, see [1], [2], [3], [4], [5], and [6].

The Bank of Canada's David Dodge on Solving Global Imbalances

David Dodge, Governor of the Bank of Canada, discusses global imbalances in The Financial Times and how their resolution is a shared worldwide responsibility, but I thought I'd go back to a more extended version of his remarks from a September 9 speech.  Among the issues cited as necessary to avoid a worldwide recession are the need for countries to adopt fiscal, labor market, financial market, and social safety net reform.  Fiscal reform will prepare countries for coming demographic challenges and also allow fiscal policy to be used, if necessary, to combat deficient aggregate demand.  The other reforms are intended to increase worldwide flexibility to respond quickly and efficiently to economic shocks and avoid prolonged recessions.  In addition, the reforms are intended to stimulate aggregate demand by reducing the need for saving.  His point that all countries have a role to play in the rebalancing effort is worth emphasizing since much of the debate on this issue has involved trying to identify a particular country or policy that explains the current situation when a combination of factors is at work:

The Evolution and Resolution of Global Imbalances, Remarks by David Dodge, Governor of the Bank of Canada: ...Today, I will talk about two types of global economic imbalances. The first relates to ... savings and investment ... being distributed across countries in an increasingly uneven way. The second is the possibility that, over the next couple of decades, the global economy might face a protracted period in which desired savings exceed planned investment, partly because of demographic trends. If economic policy-makers do not take appropriate measures quickly enough, there is even a risk—albeit a small one—that the world economy could end up with ... widespread demand deficiency and a persistent deflationary gap. ...Geographical imbalances are not necessarily a bad thing, nor are the large capital flows that they generate. Indeed, ... world financial markets ... allow savers in one country to lend to borrowers in another. Such a process leads to higher global growth ... If markets ... operate without interference, imbalances can resolve themselves in a reasonably smooth manner. But in the absence of appropriately functioning market mechanisms, there is a greater risk that the correction will be abrupt and disorderly. ... a disorderly correction might also lead governments to adopt wrong-headed protectionist measures... [R]egardless of how these imbalances are resolved, it is clear that the resolution will require greater net national savings in the United States. Investment in the U.S. economy will need more financing from domestic sources ... This implies an increase in net U.S. exports and a decrease in net exports elsewhere in the world, as well as an increase in domestic demand in other countries. Exchange rate movements have an important role to play in this regard, ... efforts by some countries to slow or prevent required adjustments by pegging exchange rates are ... counterproductive. ... such policies raise the risk of a much larger and more disorderly correction in the future, as well as an outbreak of protectionism... Within the United States, higher interest rates can be expected to lead to increased savings. Authorities could also encourage greater national savings with a tighter fiscal policy. And they could implement ... reforms to encourage national savings through taxation ... and other measures. But if the United States alone were to act to resolve its imbalance ... it would leave the global economy with much weaker aggregate demand. And so a number of other countries must focus on stimulating domestic demand. ... So, how can we stimulate domestic demand outside the United States? ... Structural reforms to remove market rigidities are important for most of us. Many need to improve or develop their financial system ... For some, the development of social safety nets would be helpful, so citizens don't feel the need to hold excessive precautionary savings. And for a few, more stimulative fiscal policy would be helpful.

...[T]he second type of imbalance ... will be posed by evolving economic and demographic realities. ... Let me ... expand on this risk by highlighting two trends that will be important over the next decade or two. First, ... Asia's share of the world economy will continue to grow. ... Asian nations have traditionally had a higher rate of savings ... so, all other things being equal, we can expect that global desired savings will rise. But all other things are not equal. The second trend that we can expect is higher desired savings in most OECD economies as the baby-boom generation prepares for retirement. Taken together, these two trends can certainly be expected to lead to a higher level of global desired savings. So it is critical for policy-makers to act now, so there can be an increase in demand and investment to compensate... To deal with this expected slower growth in domestic demand, ... what can policy-makers do to support  ... private consumption, government spending, and investment? In terms of investment, ...  First, one might look to governments to provide an expansionary fiscal policy. ... Certainly, the economies of emerging Asia have the scope to support demand with fiscal policy. But in North America, Europe, and Japan the scope for fiscal policy ... appears to be very limited ... But if there is one thing that all governments can do to stimulate demand, it is to have appropriate structural policies ... We all need to take steps to improve the flexibility of our labour markets ... We also need to recognize that well-functioning credit markets are extremely important ... The improvement of labour and financial market policies is particularly important in Europe. In emerging Asia, improving income-security policies is essential ...In closing, ... I'm not saying that a disorderly correction to global imbalances is certain to happen. Nor am I saying that the global economy is inevitably headed for a deflationary shortfall in demand. What I am saying is that, as prudent policy-makers, we must not rely on good fortune to help us muddle through...

Australian Reserve Bank Governor: Global Imbalances not Caused by U.S.

This is a discussion by I.J. Macfarlane, Governor of the Reserve bank of Australia, on global trade imbalances. What's different about this discussion? He does not believe global imbalances are caused by developments within U.S. He also has five key developments (empirical facts) that any theory of the current account imbalance must explain. His contention is that a story with the U.S. as the cause of global imbalances cannot explain all five of these developments. At the end he asks, and answers, the question of whether he lets the U.S. off too easily. Finally, he is dismissive of excess liquidity stories.  It's a bit long, but not quite as long as it appears as it includes graphs, footnotes, and references:

What are the Global Imbalances?, I.J. Macfarlane, Governor, Talk to Economic Society of Australia Dinner, Melbourne - 28 September 2005:

I was told to remove this speech by the media office of the Reserve Bank of Australia (RBA).  I am used to policies such as these:

Unless otherwise specified on this web site, reproduction         of any Federal Reserve Bank of San Francisco Information contained herein may be made without limitation as to number, provided however, that it is not distributed for the purpose of private gain and it is appropriately credited to the Federal Reserve Bank of San Francisco.

Unfortunately, the RBA is more restrictive. Apologies to readers - the speech is still available in the link above.

Will Changes in Consumption, Investment, the Social Safety Net, or the Exchange Rate Reduce Saving in China Anytime Soon?

The Economist reports on China's high saving rate, nerly 50% of GDP, and the prospects for change in the near future.  While saving has slowed recently, investment has slowed even faster leading to a more rapid accumulation of saving.  There are solutions to the saving imbalance in China, Chinese consumers could increase consumption and reduce saving, domestic investment could pick up, social safety nets could be improved, or the yuan could be revalued, but according to this analysis, the prospects for a quick adjustment in any of these factors do not look promising:

The frugal giant, by Minton Beddoes, The Economist: ...[T]he world ... is still waiting for a big Chinese consumption boom. ... the Chinese are spending a lot more than they used to. ... But Chinese saving is growing even more rapidly. Since 2000, the country's overall saving rate-already the world's highest by far-has risen sharply, to nearly 50% of GDP (see chart). Even though China is investing at the staggering rate of 46% of GDP, it is still running a net saving surplus, and that surplus is still growing... and shows no signs of stopping.

 

...China's capacity for thrift has long perplexed economists... What is going on? Household saving is the easiest to make sense of. First, Chinese households have not changed their consumption patterns fast enough to keep up with the huge rise in their incomes. ... a large part of China's growing income has been going to the relatively small share of the population living in coastal areas. Richer people save more than poorer ones. ... Moreover, the one-child policy has made it harder for people to rely on their children as a source of support in old age, further encouraging thrift. ...  A further incentive to saving is the weakness of social safety nets. Under the old economic regime many Chinese workers could count on health and pension benefits from state enterprises (the "iron rice bowl"). No longer. ... Pension coverage is low ... Health care is also getting more expensive. ... Education, too, requires deep pockets ... The relative lack of credit is another factor... consumer credit is still in its infancy. ... Like the Japanese in the 1960s, the Chinese need to save a lot because they find it hard to borrow.

       

And save a lot they do. Chinese household saving, at around 25% of disposable income, is astonishingly high ... But ... they were not responsible for the sharp rise in national thrift since 2000. ...China's household saving rate has been more or less steady since 2000 (see chart). The recent rise in national saving was led by ... the corporate sector. ... China's firms are now bigger savers than its households. But unlike their peers in the rest of the world, they are investing their surpluses... That splurge may well prove unsustainable. Profit growth has slowed sharply over the past year ... Slower profit growth means less corporate saving, but investment seems to be slowing even faster ... the pace of China's investment is likely to fall over the medium term...

What happens to China's national saving surplus will depend on whether China's households will save less and spend more, thus becoming the engine of the domestic economy. The example of Japan is sobering. Although Japanese households now save much less than they used to, their country never really made the shift from export-led to consumer-led growth. ... China, however, is different in important ways. Its economy is already much more open than Japan's ever was. ... And ... China seems to be shifting away from an undervalued currency far more quickly than Japan did. ... but this is likely to take several years. Although American policymakers may be clamouring for a rapid rise in the yuan, there is no sign in Beijing that the government plans anything of the sort. ... A government that depends on rapid economic growth to legitimise itself will not want to risk instability with a sudden rise in the currency, so a much stronger yuan seems an unlikely route to a quick reduction in China's saving surpluses. ... Redirecting an economy as big as China's towards domestic consumption takes time. China's saving surpluses will not last forever, but nor will they disappear overnight. And trying to move too fast can be disastrous, as the mess in Asia's other emerging markets shows.

The Economist: Global Saving and Investment

The economist begins its series on explaining the pattern of global saving and investment which is intended to shed light on the low long-term interest rate puzzle with a useful summary of theories of why people save and why people invest:

What causes people to save and invest?, The Economist: At first sight, the idea of a “saving glut”—an excess of saving over investment—seems odd. According to the economics textbooks, saving and investment are always equal. ... And indeed that is true for the world as a whole, but it is not true for individual countries. ... the amount an individual country saves does not have to be the same as the amount it invests. The difference between the two is the amount borrowed from or lent to foreigners; this is called the current-account deficit or surplus... Moreover, whereas it is true that at a global level saving must equal investment, the fact that saving and investment end up in balance does not mean that ... households and individuals ... desire to save and invest in equal measure. ... Actual saving and investment must be equal. Desired saving and investment may not be.

Most of the time, ... If people's desire to save exceeds their desire to invest, interest rates will fall so that the incentive to save goes down and the willingness to invest goes up. Across borders, exchange rates have a similar effect. ... But there is some uncertainty about how smoothly these adjustments are made. Classical economic theory suggests that interest rates automatically bring saving and investment into a productive balance. The central principle of Keynesianism, however, is that this alignment between saving and investment is not always automatic, and that a misalignment can have serious consequences. ... The modern consensus is that both classical and Keynesian theory can be right, but over different time frames. In the long term, saving and investment will be brought into line by the cost of capital. But in the short term, firms' appetite to invest is volatile, and policymakers may need to step in to shore up demand. Thus, although saving and investment are equal ex-post, economic theory leaves plenty of room for an ex-ante saving glut...

What might change people's desire to save or invest? ... The most influential theory of household saving is the “life-cycle hypothesis” ... It suggests that people try to smooth consumption over their lifetime: they save little or nothing when young but more in their middle years if they have a good income. They then draw down those savings in retirement. ...demographic shifts and economic growth are the most important drivers of thrift. Another theory suggests that people save for “precautionary reasons” ... This implies that people will save more if their income is variable. It also suggests that they will be more inclined to save if they have no access to credit. A third possibility is that people save because they want to leave assets to their children, either because they love them or as a way to bribe the children to look after their parents in old age. ... the bequest theory of thrift suggests that savings might not actually be drawn down in retirement. A final possibility is that people save in response to their government's actions. This theory, known as “Ricardian equivalence”, suggests that people save more if government saves less because they expect higher taxes later on. How well do these theories fit with what has actually happened in the past? ... in general, the following factors seem to play a role:

•Demographics. ...Saving rates do rise when the ratio of children in the population falls (as in China), and decline when the proportion of pensioners rises (as in Japan). Given that the world's population as a whole is ageing ... global saving should currently be rising.
•Economic growth. Especially in poorer countries, saving rates rise as economies grow. That is probably because people do not adjust their consumption patterns as quickly as their income rises...
•Terms-of-trade shock. If a country's exports suddenly go up in price, its saving rate tends to go up too, at least temporarily. Oil exporters, for example, put on a saving spurt if oil prices rise. This effect also helps to explain the recent increase in saving in many emerging economies.
•Financial development. As an economy's financial system becomes more developed, saving rates tend to fall because people find it easier to borrow. ... It suggests that saving rates may be lower in countries with more sophisticated financial systems, such as America.
•Capital gains. In rich countries ... If the stock market or house prices rise, people feel richer and save less. A study by the OECD published late last year suggests that housing wealth has a bigger effect on saving than financial wealth...
•Fiscal policy. In some countries, people do appear to behave as Ricardian equivalence theory suggests: they save more when budget deficits expand, perhaps because they expect higher taxes in the future, although private-sector saving rises by less than the rise in budget deficits. The big exception is America, where the impact of fiscal deficits on private saving appears to be weakest.

Some of these factors work in opposite directions ... But there are indications that in rich countries the biggest disincentives to saving have been capital gains and the ability to borrow. ... In emerging markets, on the other hand, the most powerful factors pushed in the opposite direction. Fast economic growth and increases in government saving, thanks partly to terms-of-trade shocks, have increased total national saving. ... If there is a glut of saving, it is likely to be found in emerging economies and oil-exporting countries.

...In theory, firms should invest if the expected return on their investment exceeds the cost of the capital they are using. In the short term, firms need to worry about the state of overall demand. But in the long term, returns on capital depend on how much capital an economy already has, how productively it is used, and how fast the workforce is growing. If there is little capital available or the workforce is growing rapidly, firms would usually expect a high return on investment. The evidence supports these theories, up to a point. ... However, in recent years these statistical relationships have failed to hold. Both in rich countries and in emerging economies (except China), investment levels have been lower than economists had expected at the levels of interest and growth rates prevailing at the time. Much of Mr Bernanke's saving glut is due to this unexpectedly low rate of investment. ... several “structural” explanations have gained support:

•Demographics. A young and growing workforce boosts the level of investment, just like a mature workforce boosts the saving rate. ... But although demographics are important, they change slowly. It is hard to ascribe the recent sharp drop in investment demand in regions such as Japan or East Asia to demographic change alone.
•Declining capital intensity. Firms in rich countries may not need to invest as much as they used to because the share of capital-intensive industries in their economies is shrinking. ... But [this] does not explain investment busts in poor countries.
•Deflation of capital-goods prices. In recent years prices of capital goods have fallen sharply relative to prices of other goods and services, thanks largely to cheaper computers, so companies are able to achieve the desired level of real investment for a smaller outlay. ... This may help to explain some of the recent weakness in investment, particularly in rich countries. But it is unlikely to last. ... More important, computers depreciate more quickly than other capital goods, so eventually firms will need to invest more to maintain the same level of net investment.
•The rise of China. This may have prompted a geographic shift in global investment patterns. ... But investment flows to China from America, Europe and Japan are not yet big enough to explain the sluggish investment in those countries...

In sum, none of these explanations for a structural, global decline in investment is altogether convincing. To understand the pattern of global saving and investment properly, you have to look in detail at what is going on within the world's main saving and borrowing countries. The best place to start is the biggest net saver of all, Japan.

More to follow...

The Global Dearth of Investment

The Economist argues that low long-term interest rates are not due to a global glut of saving as some have claimed, but rather to a lack of global investment.  We’ve had this debate before based upon an article in The Economist, e.g. see here, particularly Brad DeLong, William Polley, PGL at Angry Bear, and this paper from the NBER. I agree with the conclusion reached at that time – low long-term rates are explained by both a lack of global investment relative to saving and by excess liquidity.  In IS-LM jargon, this is an inward shift of the IS curve and an outward shift in the LM curve as shown in DeLong.  Unlike the previous editorial in The Economist that claimed excess global liquidity explained low long-term rates, this article focuses on the inward shift in the IS:

Don’t blame the savers, The Economist:  …America’s fiscal profligacy … contribut[es] to the imbalances that currently threaten the health of the world economy. That is precisely the verdict of the newly released chapter on savings and investment in the International Monetary Fund’s World Economic Outlook. The document highlights the danger posed by the world economy’s heavy dependence on ravenous American consumers to snap up exports from the rest of the world. To be sure, it is hard to be too gloomy. … world GDP is still growing at an above-average clip. ... But dark clouds have been gathering on the horizon for some time. Emerging-market economies, particularly in Asia, are running high current-account surpluses, keeping their economic fires stoked with a steady stream of exports, especially to America. In mirror image, America’s current-account deficits have soared past 5% of GDP. Household savings have dwindled to negligible levels as Americans have run down assets and taken on debt to keep the spending binge going. Yet if the American consumer falters, as things stand now, the rest of the world will tumble too. Moreover, economists are increasingly worried that America’s economic health … rests on a housing market that looks decidedly bubbly. … But if economists are agreed that America’s debt levels are dangerous, they cannot agree on whom to blame. … the government’s profligate budget deficits … which run down national savings. …[or] … spendthrift consumers, … the frothy housing market, and … a “global savings glut” … pouring excess capital from abroad, particularly Asia, into America’s financial markets...

America is not the only country where savings have fallen. Worldwide savings began declining in the late 1990s, hitting bottom in 2002. They have recovered only modestly since then. The drop is mainly due to industrial countries, where savings and investment have been on a downward trend since the 1970s... Savings in emerging markets and oil-producing countries have risen over that period, but not enough to reverse the trend. So why the sudden talk of a savings glut? ... The IMF report offers an explanation. What the world is suffering from is not so much a savings glut as an investment deficit, in both rich and poor countries. In emerging markets and oil-exporting nations, still feeling the lingering effects of the Asian financial crisis of 1997-98, demand for capital has failed to keep up with supply. Scrimping consumers have instead sent their money to the West. The IMF’s figures suggest that this is not as irrational as it seems. … investments in emerging markets are riskier, because their economies tend to be more volatile and their institutions weaker. Moreover, … the IMF’s analysis suggests that the internal rate of return ... in emerging markets has been very poor over the past decade, even before currency risk is taken into account. But investment has fallen in the rich world too: the rivers of capital have flowed not directly into businesses but into markets for consumer and government credit, where they are presumably doing little to increase the recipient economy’s ability to repay the loans in the future… So what is the cure? Lower savings rates in emerging markets? That would be a disaster, according to a new report from the World Bank … Like the World Bank, the IMF does not think lower savings rates in developing countries are the answer. It identifies several other things that could make a difference: higher national savings in the United States, an investment recovery in Asia, and an increase in real GDP growth in Japan and Europe. Easy to say, difficult to pull off. Raising interest rates would, the IMF concedes, have only a limited effect on America’s savings rate. Balancing the budget would do more, but there seems to be little political will to tell Americans they must pay for their government programmes. Across the Atlantic, European governments are finding it hard to make the kind of structural reforms that could boost their sluggish growth rates, and the European Central Bank has remained unwilling to provide monetary stimulus by cutting rates. Nor has Japan’s government, despite the signs of fledgling recovery, yet found a formula for boosting its long-term growth rate. It is easier to diagnose the illness than effect a cure.

Progressive Tax Reform Democrats Can Support?

The tax reform issue is about to heat up – when congress reconvenes in September tax reform will be at or near the top of the administration’s agenda and, given the outcome of Social Security reform efforts to date, we can expect this to be undertaken with an eye towards success at most any cost. Thus, Democrats have a choice to make.  Should they try to block GOP proposals for tax reform or get out in front of the issue, if it’s not too late already, with a proposal of their own?  Given that the status quo with respect to tax burdens, shifting income distributions, and other changes is not acceptable to Democrats, and that the GOP reform proposals are not acceptable either, serious consideration should be given to a counter tax reform proposal that embodies principles of equity Democrats wish to promote.

401(k) Opt-Out Regulation Proposed by Labor Department

A proposal from the Labor Department would encourage firms to automatically enroll workers in 401(k) accounts.  If enacted, it’s not clear if this will undermine the perceived necessity for Social Security reform involving add-on accounts based upon the need to increase national saving, help to open the door for more general reform, or have little effect on the political debate:

Rule would encourage automatic 401(k) enrollment, by Kathy Chu, USA Today:  The Department of Labor expects to propose a regulation by year's end that will encourage companies to automatically enroll their workers in 401(k) plans. … Once the regulation is proposed, the public will be able to comment on it before it becomes final. The regulation could affect millions of workers in 450,000 retirement plans. … The Labor Department says the proposed regulation should give employers who automatically enroll workers in a 401(k) plan some protection from lawsuits if the investment options chosen are "reasonable." Some companies are reluctant to use automatic enrollment for fear that employees whose investments lost money would sue. … Many companies that automatically enroll employees use conservative money-market or stable-value funds as a default. ... If employers view the Labor Department's guidance favorably, it could be seen as removing the last barrier to automatic enrollment … Automatic enrollment can be extremely effective in boosting 401(k) participation, especially among young and lower-income workers … Taking advantage of 401(k) plans is becoming increasingly important as companies drop pension plans…

The Paradox of Thrift II

Samuel Brittan of The Financial Times echoes the theme of "The Paradox of Thrift" in his discussion of attempts by governments to increase saving:

Myth of national savings drives, By Samuel Brittan, Financial Times (subscription):  … Today I want to tackle the myth of national savings … we have been besieged with exhortations to save more. ... The excuse ... is the supposed need to increase physical investment. Even if we accept this “need”, the case for savings drives is not made. Between the world wars Lord Keynes pointed out that an excessive attempt to save could bring about a slump. ...  In today’s globalised economy there is another critique of savings drives. It is simply that a country’s investment is not limited by domestic savings ... There is … a fundamental worldwide “ex-ante” savings surplus. … In the present world conjuncture the last thing we need is for the US to start saving much more ... This would simply add to the very high Asian levels of savings and the moderately high continental European levels. It could then be difficult for real interest rates to fall enough to accommodate such a surge in world savings...

I want to add one note from the post linked above.  This does not rule out attempts to increase saving as a means of increasing economic security, e.g. for retirement saving, or as a means of solving potential market failure problems in these markets.  Those are separate issues.

The Paradox of Thrift

The marginal average propensity to save out of income was zero last month.  But wealth is still increasing due to rising home prices.  Because of this households are spending more, an average, than they are earning:

The zero-savings problem, By Chris Isidore, CNN/Money:   … Even as a government report Tuesday showed the national savings rate at zero -- that's right nada -- the rise in the value of homes has given the average U.S. household a net worth of greater than $400,000, according to a separate report from the Federal Reserve.  Household real estate assets have risen by just over two-thirds since 1999, and the run up has enabled consumers to spend more money than they are bringing home in their paychecks. … "[Rising home values] are making people feel they don't need to save," said Lakshman Achuthan, managing director of the Economic Cycle Research Institute. … June was only the second month the rate was at zero since the monthly figure started being calculated in 1959. ...  Strong auto sales in June played a big part in the latest read on the savings rate. The government counts the entire price of the autos purchased during the month, even though most consumers pay for vehicles over time.  But even if that zero savings rate is a bit of a quirk, the trend towards lower and lower savings rates is unmistakable. In May, before the current "employee pricing" offer from automakers, the savings rate was only 0.4 percent, … As recently as 1994, the savings rate was nearly 5 percent. Go back 25 years and double-digit savings rates were the norm. … The low savings rate has kept consumers spending, which in turn has kept the economy growing.  "We've backed ourselves into a very dangerous situation," said Dean Baker, co-director of the Center for Economic and Policy Research. "The economy is dependent on everyone consuming like crazy. If everyone heard my diatribe and said, 'Yeah, we better start saving,' the economy would go into a recession." …

As noted, the cost of higher saving is lower output and employment.  But there is also, presumably, a benefit.  More saving generally leads to more investment because it reduces interest rates, and higher investment leads to more output in the future.  By giving up consumption today even more will be available in the future.  But today, with interest rates already so low, the benefit of increased saving will be less than in the past since there is unlikely to be much stimulus to investment.  Increasing national saving is a worthy goal, and it enhances economic security, but it may lead to reduced output and employment in the present without much compensation in terms of increased production in the future.

[Update: Please see Paradox of Thrift II as well].

Caution! Lobbyists at Work

Insurers are trying to ensure themselves a share of the retirement security market by lobbying for favorable legislation such as tax breaks for retirement annuities:

Insurers Want Their Say in Social Security Debate, By Joseph B. Treaster, NY Times:  … regardless of the outcome of Republican proposals to add private accounts to the system, the nation's huge life insurance industry stands to benefit from the debate over Social Security's future. Already, the debate has called attention to retirement concerns. Insurers have been increasingly focusing on selling investments for retirement and they are doing their best to capitalize on the attention. Moreover, if Congress does end up changing Social Security, there is a good chance any new law would favor the kind of investments called annuities that insurers love to sell. … [T]he insurers have strengthened their main trade association and lobbying arm, the American Council of Life Insurers, and many individual companies are working independently to win advantages for their products. Last year, the trade group alone reported spending $9.1 million on lobbying, up 54 percent from the previous year. … In making their pitch now, the insurers emphasize that their annuities can contribute to national savings and provide "a paycheck for life" similar to Social Security. They also contend that a flexible savings plan advocated by President Bush, which would probably take money away from them, would probably not increase long-term savings. And the insurers are trying to prevent the elimination of the estate tax, which many wealthy Americans now pay with the proceeds of life insurance policies. … The lobbying campaign may already be paying off. Some of the most powerful Washington leaders have been picking up on the broader issue of retirement and the woeful inadequacy of savings by most Americans…

Bad News for Opt-Out Accounts

This is not good news for add-on, opt-out accounts.  Younger workers, when forced to make a choice due to departure from a firm cash out their retirement saving plans in large numbers.  This implies that, when faced with checking a box on a tax return, something that requires active participation, many may opt-out and those that do may be the workers most likely to benefit from such accounts in the long-run.  Thus, the ability of these accounts to increase national saving and solve market failure problems in the retirement savings market is suspect if these statistics carry over to opt-out, add-on accounts:

Designing Optimal Opt-Out Retirement Saving Plans

This is for my records (papers on designing savings plans to maximize participation as discussed in the post below this one for the Academic Papers category I am building).  These are all by James Choi at Yale (the link is to a Harvard page, the Yale page is here):

"Optimal Defaults and Active Decisions" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). December 2004.

"Saving for Retirement on the Path of Least Resistance" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). In Ed McCaffrey and Joel Slemrod, editors, Behavioral Public Finance, forthcoming.

"Plan Design and 401(k) Savings Outcomes" (with David Laibson and Brigitte C. Madrian). National Tax Journal 57, June 2004, pp. 275-298. Summarized in October 2004 NBER Digest

"Employees' Investment Decisions About Company Stock" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). In Olivia S. Mitchell and Stephen P. Utkus, editors, Pension Design and Decision-Making Under Uncertainty, forthcoming.

"Optimal Defaults" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). American Economic Review Papers and Proceedings 93, May 2003, pp. 180-185. "Passive Decisions and Potent Defaults" is a longer version of this paper.

"For Better or For Worse: Default Effects and 401(k) Savings Behavior" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). In David Wise, editor, Perspectives in the Economics of Aging, pp. 81-121. Chicago: University of Chicago Press, 2004. Summarized in April 2002 NBER Digest

"Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance" (with David Laibson, Brigitte C. Madrian, and Andrew Metrick). In James Poterba, editor, Tax Policy and the Economy 16, 2002, pp. 67-114. Summarized in April 2002 NBER Digest

Why Do So Many Households Hold So Few Interest-Bearing Assets?

I'm not sure this post will inspire as many comments as the post below it, but increasing national saving is an important issue both generally and in the Social Security reform debate, so I thought I'd present some empirical evidence on how the accumulation of financial assets by households changes as households become more informed about financial markets. A paper by Casey Mulligan (University of Chicago) and Xavier Sala-i-Martin (Columbia University) appearing in the Journal of Political Economy, Vol. 108, No. 5. (Oct., 2000), pp. 961-991 (JSTOR stable URL – subsc.) reports that according to the Survey of Consumer Finances, 59% of U.S. households hold no interest-bearing financial assets over and above employer held pension funds and IRAs. Why do so many households hold so few assets? The authors argue that the transactions and learning costs of entering financial markets are sufficiently high so as to more than offset the expected earnings for most households. They also suggest that people with retirement fund assets such as employer held pensions and IRAs have lower transactions and learning costs because their exposure to retirement assets may bring additional understanding of how such markets function. They find that “(a) the elasticity of money demand is very small when interest rate is small, (b) the probability that any individual holds any amount of interest-bearing assets is positively related to the level of financial assets, and (c) the cost of adopting financial technologies is negatively related to participation in a pension program.”

I want to focus a bit more on (c) which tells us that participation in a pension program increases the likelihood of holding financial assets at all income levels. The Social Security debate is often centered around the idea of an ownership society for lower and middle income class workers so the focus will be on households with low amounts of financial wealth. A new econometrics textbook that will be out this fall uses data from the study to investigate this issue. The example in the book asks “How likely is an individual with $1,000 in total assets to hold any of it as interest-bearing assets if he or she has no retirement accounts?." At an asset level of $1,000 the probability (from probit estimates) that an individual will hold any of the $1,000 in interest bearing assets is 12%. However, when an individual already has a pension plan of some type, the probability of holding additional financial assets rises to 18%. Also, note that these percentages pertain to a particular asset level, $1,000, and according to result (b) the percentages increase as the asset level increases.

This is evidence that one of the barriers to entering financial asset markets is the cost of learning how they operate. This may also explain why discussions of add-on accounts have noted much higher participation rates with opt-out as opposed to opt-in programs. There is a much larger incentive to learn what you need to know to protect the principal or liquidate the assets than there is to put the assets into a retirement account. That is, if the investments are automatic or if particular funds, etc. must be chosen there is an incentive to make sure the principal is protected and to learn the rules under which the principal can be drawn down if needed. In the process needed knowledge is obtained. When the system is opt-in, the expected return is not sufficient to trigger the learning needed as a prerequisite to participation in financial markets.

Let me be clear. I believe the solvency issue has been oversold and we do not need to radically alter the Social Security program. This is in no way a call for private accounts to solve some imagined hyped-up problem. But decreasing the barriers to participation by lower and middle income households in financial markets is an important goal and this tells us something important about how to do that. As I watch colleagues fret over the very few retirement options available to them (me too), and these are Ph.D. economists, and as intelligent friends ask questions about annuities (like what the heck are they?), etc., it seems to me that these barriers are substantial.

I do not know if it is lack of knowledge of the types of financial assets, their risk-return characteristics, knowing where to go to purchase assets at the lowest fee, and so on that constitutes the biggest barrier to participation. But the change in participation rates from 12% to 18% in the numbers above at relatively low asset levels from simply having a pension account no matter how passive the participation suggests there are potential gains to be made through better education. Less than full information among participants is a known market failure, especially when information is asymmetric (why do annuities come to mind again?). My casual observation, and more to the point empirical results, suggest lack of information is a substantial problem. If we can identify and overcome areas where lack of knowledge is a barrier to participation, perhaps we can increase participation in financial markets at all income levels, particularly among low to middle class households.

What is the most important informational barrier? Is it as simple as knowing where to go to buy an asset like a T-Bill, corporate bond, or index fund? Or is it a lot more than that?

Social Security Legislation to Include 401(k) Opt-Out Accounts

News that House Ways and Means Chairman Bill Thomas will support opt-out 401(k) accounts as a part of Social Security reform legislation:

Automatic Signup In 401(k)s Backed - Provision Eyed for Social Security Bill, By Jonathan Weisman, Washington Post: House Ways and Means Chairman Bill Thomas (R-Calif.) will include a provision in his Social Security legislation to help employers make enrollment in 401(k) plans automatic unless workers choose to opt out, according to congressional staff and knowledgeable lobbyists. The provision could have substantial impact on the nation's savings rate … Recent academic research has shown that employee participation rates soar among companies with automatic enrollment in retirement plans. … lobbyists who have met with Thomas say he has given his word on the matter.

… According to two lobbyists familiar with the discussions, Thomas has suggested to life insurance interests that he would back incentives for employers to convert 401(k) balances to private annuities that would pay out slowly over a worker's retirement. In exchange, the life insurance industry would not work against a dramatic expansion of Individual Retirement Accounts, 401(k)s and tax incentives designed to expand personal retirement savings. … Economists of all political stripes like it because it appears to work. … Mandating automatic enrollment would easily create $20 billion in new retirement savings a year, said Peter R. Orszag, director of the Retirement Security Project … If Congress pushed employers to slowly increase contribution rates over time, savings would increase well in excess of $50 billion a year. …

I’ve been wondering whether to support such a proposal. The first question I had, which I asked here, was what market failure justifies intervening to increase saving? If the loanable funds market works, wouldn’t the saving rate, whatever it is, be optimal? Through comments and an email, I am now convinced that taxes drive a wedge between private and social investment returns, that myopia might play a role, and that moral hazard may also be a problem resulting in saving below the golden rule level. Thus, I am now comfortable with government intervention to create incentives to increase private saving.

That brings me to opt-out. I believe it increases saving relative to opt-in, but why is this so? Do some people perceive the transactions costs of changing status to be greater than the benefits irrespective of whether they are asked to opt-in or opt-out? In general, I hate opt-out programs. I don’t want to spend my time filling out forms and checking boxes telling people all the things I don’t want to buy. If I’m convinced there is market failure in the market for bicycles resulting in too few being purchased, is the proper solution to drop bicycles in people’s yards unless they remember to send in the proper paperwork? I remember being in music clubs like that when I was younger… Maybe a better answer is to work a little harder on the incentives and ease of opting-in.

Last, I worry we have forgotten the Lucas critique yet again. Change the rules and change the behavior. I can imagine that if you impose opt-out now when it is uncommon participation might be high. But as it becomes more common and institutionalized people will more easily opt-out. In addition, it also seems participation rates will fall in the long-run as people hit financial stress points. If you can opt-out at will, then the first time a family faces financial distress, they will likely opt-out. Unless they are somehow brought back into the program later, participation rates will fall as time passes and revenues may not meet projected values.

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Is There Market Failure in the Loanable Funds Market?

Here's something I've been wondering about and I hope someone can help me. I hear repeatedly that the national saving rate it too low. I am not arguing against that idea, one that has been around since the mid 1990's, but why is this?

The right is a strong proponent of using Social Security reform to increase the saving rate. What market failure justifies such intervention into the private sector? Why doesn't this market produce the proper amount of saving? What market failure are those on the right, and others (many on the left embrace this as well), trying to correct in their call to increase saving through Social Security reform such as add-on accounts?

Is it due to a distortion arising from the federal budget deficit, low interest rates from Fed policy, or some other government policy? If so, why not fix the distortion rather than try and further manipulate the market to increase saving?

Before intervening, shouldn't we at least identify the market failure? And if there is no market failure, if markets always work as many believe, should we call for intervention?

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Evidence That Matching Funds Increase Saving

The New York Times reports the results of an experiment to see how well matching funds work as a mechanism to increase saving. The results show that matching funds cause an increase in the number of people who save and increases the average amount saved by each individual. This implies that add-on accounts with two features, government or employer matches and opt-out rather than opt-in provisions are an attractive option to pursue in reforming Social Security in a way that increases national saving. There is direct evidence that matching funds increase saving, and though the opt-out provision is not examined directly, the study does show that ease of making the contributions is important:

H&R Blockbuster, NY Times: … Half of all American households have little, if anything, saved specifically for retirement … conventional wisdom holds that there's no way to get people to save more. Happily, the conventional wisdom is wrong. … lawmakers should pay close attention to the results of an experiment that was conducted this year at 60 offices of H&R Block in the St. Louis area. From March 5 to April 5, some 15,000 H&R Block clients, most of them low- or middle-income, were offered free help setting up I.R.A.'s. They were randomly assigned to three groups: people in one group got a 20 percent match for I.R.A. contributions of up to $1,000; another group got a 50 percent match on such contributions. Still others - in the control group - were offered no matching funds. H&R Block put up the money for the matching deposits, eventually spending $500,000. The test was designed and evaluated by researchers from the Retirement Security Project, whose lead sponsor is the Pew Charitable Trusts.

The experiment generated two broad findings: First, offering a match not only causes I.R.A. participation to rise, but also increases the amounts people contribute. A total of 1,500 taxpayers chose to contribute to I.R.A.'s; participation rates were 3 percent in the control group, 10 percent in the 20 percent match group, and 17 percent in the 50 percent match group. The average contributions for the people in the match groups (not counting the H&R Block matching funds) were at least 50 percent as high as in the control group, which got no match. Second, the information provided by the H&R Block tax preparers and the ease of contributing greatly influenced the participants' decisions to save; most of the participants simply diverted portions of their tax refunds into their I.R.A.'s. Full details of how the test isolated these and other factors that bore directly on the savers' decisions are available at www.retirementsecurityproject.org. Although it seems like common sense that offering matching funds would increase I.R.A. participation and contributions, that hypothesis had never been rigorously tested before now. And Congress has never incorporated such direct matches into the savings incentives it provides. Instead, Congress's chief tax writer - Representative Bill Thomas of California - and most of his fellow Republican lawmakers continue to emphasize new tax-deductible savings plans and higher contribution limits for the current tax-favored accounts. Such incentives have failed in the past to motivate most taxpayers to save much, and they won't work now. A big reason for that result is that tax deductions and lofty contribution limits provide the most value to affluent, high-tax-bracket filers, not to low- and middle-income taxpayers. … Lawmakers in Washington could establish a generous and easily understandable I.R.A. match for a fraction of what it would cost to extend the Bush tax cuts for the wealthy. The evidence in favor of doing so is compelling. Then, when the ideological din abates, a future Congress can enact the reforms that are actually needed to strengthen Social Security after midcentury: modest tax increases and tempered benefit cuts, phased in over decades.

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Social Security as Insurance vs. Welfare vs. Saving Once Again

Deinonychus antirrhopus, in this post,  revisits the "Is Social Security saving, welfare, and/or insurance question" following up on this post on the site two days before (my response to the earlier post is here). The vehicle generating the discussion is this post from my comment on a Robert Samuelson column.  My response to the latest post at Deinonychus antirrhopus is in the comments.  Brad DeLong also commented on my Samuelson post here.  In addition, Angry Bear weighs in nicely here on social insurance.

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Fed Governor Bies: Young Workers Face Increasing Financial Risk

Fed Governor Bies remarks on the increasing financial risk faced by young workers and their failure to take advantage of voluntary private 401(k) retirement accounts even when contributions are matched by their employers:

Remarks by Governor Susan Schmidt Bies
At the Canisius College Richard J. Wehle School of Business Community Business Luncheon, Buffalo, New York
April 18, 2005

The Economy and Managing Personal Finances

… I am expressing my own opinions, which are not necessarily those of my colleagues on the Board of Governors or on the Federal Open Market Committee…

…In the household sector, some analysts have expressed concern about the rapid growth in household debt in recent years and the decline in the household saving rate. They fear that households have become overextended and will need to rein in their spending to keep their debt burdens under control… As I have already noted, in the aggregate, household debt has grown more rapidly than income in recent years. Of special relevance to this audience is that the increase in consumer debt loads in recent years is particularly apparent among younger adults… Moreover, there are indications that some of these younger households are having difficulty managing their debt successfully… Finally, surveys continue to indicate that many workers are not currently saving for retirement, and many that are saving, by their own calculations, are not saving enough…

…Turning to retirement savings in particular, workers entering the labor force today will bear more of the risk of financial security later in life than workers of a generation ago. Far fewer workers will be covered by defined-benefit pension plans established by their employers, which provide pre-set benefits after retirement…studies have found some troubling patterns related to individual savings in 401(k) plans that suggest that workers may not be giving adequate attention to their retirement savings. First, despite the tax advantages of 401(k) contributions, one-quarter of workers eligible for 401(k) plans do not participate at all, even if the employer would match a portion of their own contributions. These workers are effectively giving up a pay raise. And among those that contribute, many save just a little. In a survey last year, one-quarter of firms reported that their rank-and-file 401(k) participants saved an average of less than 4 percent of pay…

…These patterns are troubling because they raise doubts about the financial security of workers in later life…

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Social Security and Saving

When the government issues new debt, it seems to me that there are three possibilities to consider (assuming it is not monetized):

1. The resulting rise in interest rates causes saving to increase and consumption to decrease. Thus, one possibility is the textbook case of saving increasing because interest rates rise.

2. The fall in the price of T-Bills (rise in the interest rate) causes a movement away from substitute assets into T-Bills. There is no net effect on saving.

3. The T-Bills are purchased by the foreign sector. [The experience of the EU may be relevant (see Krugman and Obstfeld page 306, 6th ed.). In that case, a reduction in the deficit had almost no effect on national saving as savers decreased private saving to compensate. Thus, the twin deficits prediction of an increase in the current account surplus failed to materialize. As K/O note, one explanation for this is Ricardian equivalence, but it is not likely the full explanation as the empirical evidence suggests Ricardian equivalence only holds in part. K/O point to increases in household wealth as responsible for the remainder of the fall in private saving. ]

4. If households are led to believe (incorrectly and therefore irrationally) that privatization will increase the expected assets available to them at retirement, saving will decrease. I will assume rationality will prevail in the end.

Then there is risk to consider:

1. Since the government's obligations are reduced under privatization and replaced by an inflow from the stock market, people may perceive a reduction in the risk of the government meeting its obligation to pay retirement benefits. Government payments are more certain since the obligation is smaller. This reduces risk and reduces saving.

2. Since individuals are now participating in the stock market, they face more risk. This will increase their saving.

Thus, the net effect depends on people's perception of the change in risk. There is more risk from being in the market, but less risk of government default. The effect on saving depends upon the individual's perception of how these risks change.

So, it seems like the overall effect is an empirical question - it depends upon relative magnitudes, and one of the influences is difficult to measure as it depends upon people's perception of changes in risk.

I've been trying to fully understand the savings debate I'm reading. With the above as a reference point, what have I left out or stated incorrectly? What other forces affect saving, or cancel the effects noted above?

Social Security is about insurance, not savings

[Link to actual article: Guest Viewpoint: Social Security is about Insurance, not Savings]

Guest Viewpoint: Social Security is about insurance, not savings, By Mark Thoma, Register Guard, February 24, 2005

When the Great Depression hit the United States in October 1929, the economic and social turmoil that followed exposed the typical family's need for economic security.

Workers who diligently endured the daily grind to support their families could find themselves suddenly thrown into unemployment simply because a new machine was invented, people changed their buying habits, production was relocated or the economy entered a recession.

Prior to industrialization, the need for economic security was not as great. In an agrarian economy, economic security is provided by extended family relationships coupled with the largely self-sufficient nature of farms.

Industrialization led to large economic gains, but the resulting migration to cities, the breakup of extended families, reliance on wage income as the primary means of support and an increase in life expectancy substantially increased the economic risk faced by the typical family. For a worker dependent solely on wages, the loss of a job means a total lack of income, not just hard times.

Without the help of others, abundant savings or some type of social insurance program, starvation is a real possibility. Even a worker who has assiduously saved for retirement can suddenly become impoverished due to such events as an illness or by living longer than expected.

Programs such as unemployment compensation and Social Security arose out of the Great Depression as a means to mitigate economic risk using the least amount of society's valuable resources.

Social Security was never intended to be an individual savings account. It was intended to provide a social safety net for people in retirement and families that lose a primary wage earner, and to provide the insurance at less expense than could be done privately.

People saving for their own retirement must save enough to sustain themselves should they live a long time or incur large health care costs. But this is not the optimal arrangement. Precisely the same goal can be attained with a smaller amount of savings by each individual. If everyone pools their funds, then each person needs to contribute only enough to support the average life and health expectancy of the group.

It is no different than fire insurance. Without such insurance, people would need to save enough to replace their homes should a fire break out. All risk must be borne individually, and most people end up saving far more than needed compared to an insurance program providing identical benefits. Others are left without any protection at all. With fire insurance, each person pays a smaller amount into a fund, and those unlucky few who need the insurance collect. There is no expectation that the amount paid in and the amount collected will necessarily match. Social Security insurance is no different.

But why does the government need to provide such insurance? Couldn't the private sector offer it instead to those interested in participating?

Before 1935, there was no such private insurance system available, so that is one reason to suspect the private sector will not offer such insurance. The lack of adequate pension plans offered by employers today is another.

In addition, economic theory suggests this may be an instance of market failure - that is, a case in which the private market does not provide the optimal amount of a good or service, such as insurance. Government intervention is necessary to correct the market failure.

Even if insurance is provided by the private sector, when left to provide for themselves many people do not make good decisions on saving for their retirement years. Social Security was created to solve the problems that arose when such insurance was left to the private sector.

The privatization debate has not paid enough attention to the insurance aspect of Social Security. It is social insurance, not an individual savings program, and it is important to recognize why it is optimal for government to provide social insurance collectively rather than leaving it to individuals.

Leaving it to the private sector didn't work before 1935, and there are good reasons to believe it won't work now.

Whether Social Security actually needs fixing is another debate. If it is to be fixed, anything that threatens to undermine the social safety net - and privatization is a step that pushes in that direction - also threatens the social contract the government forged with its citizens to provide for their economic security.

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