The U.S. savings rate was a dismal 0.2 percent of Gross Domestic Product in the third quarter of 2004, and nobody but economists seemed to care. Once foreign central banks stop financing the United States’ twin trade and budget deficits, this will have to change, or crisis will ensue. Changing the ingrained U.S. spending habit won’t be easy, and will certainly be unpopular.
Alan Greenspan, speaking Friday in Frankfurt, remarked that “a diminished appetite for adding to dollar balances must occur at some point.” This caused a further drop in the dollar, currently trading at a record low of below $1.30 = 1 euro. Meanwhile, the U.S. payments deficit in September remained over $50 billion, leading inexorably to an annual deficit above $600 billion, easily a record in nominal or real terms. To rectify such a deficit, the dollar would have to drop enormously, probably to about $1.80 = 1 euro. There is zero chance that the European Union, already plagued by near- recession, would allow that to happen – why should they? Unlike the United States, the EU’s trade flows are close to balance and its budget deficits, while causing much hand-wringing around Europe, are overall somewhat smaller than that in the United States. Thus a sharp increase in the dollar’s value against the euro would de-stabilize the EU economies, without bringing the bloc any benefit in return.
Looking at the economic arithmetic, if private saving is very low in relation to investment, and government is also dis-saving, then there are only two places for the money to come from to make the system balance: companies and foreigners. Foreign capital inflow balances the payments deficit, and depends currently on the political whims of a few Asian central banks, while corporate saving is a product of the recent increase in company profits, which has not been accompanied by a surge in investment, an imbalance that is unlikely to continue ad infinitum – either profits will drop or investment will rise. Thus, if foreigners slow their purchases of U.S. Treasuries, either the value of the dollar must collapse or the government must balance the budget or private saving must increase. Assuming no massive outbreak of fiscal Calvinism in Washington, it all comes down to a sharp increase in the volume of private saving, by at least 5 percent of gross domestic product — the system is unstable in the long run without it.
A more difficult question, however, is how such an increase can be achieved.
For a start, interest rates need to go up, by a lot. Currently, short term interest rates are well below the “true” inflation rate, currently at least 4 percent and rising (readers will remember from several recent columns that the official “hedonic” inflation figures understate the true level by around 1 percent.) Even long term real interest rates on Treasury bonds are hovering round the zero mark. This has been the case for several years now; it is little wonder that U.S. individuals aren’t saving – they are given no incentive to do so! To produce a change in consumer behavior, even if taxation and other measures are also adopted, both long term bond rates and short term rates must rise above 7 percent, a real interest rate at present inflation levels of around 3 percent, approximately the mean risk free debt rate in a stable economy (in practice rates may need to rise even more than this, but certainly not less.)
The Federal Open Markets Committee has taken to raising the federal Funds rate by ¼ percent every time it meets. Unfortunately, it only meets 8 times a year, so at this pattern can only raise the Federal Funds rate by a further 2.25 percent, to 4.25 percent, by the end of 2005, leaving monetary policy accommodative throughout the year, which in turn will produce a further increase in inflation, to at least 6 percent, by December 2005. This would be a disaster – the Fed would be raising interest rates more slowly than inflation would be accelerating, and would never catch up. Hence, unless the FOMC takes to meeting more often, it must raise rates more sharply than it is currently doing; until it does so, its true policy will remain hopelessly over-accommodative.
Raising interest rates to their current equilibrium level of 7 percent will play merry hell with Wall Street and the housing market. The “Fed model” for stock prices, popularized in the mid 1990s to justify higher valuations as the stock market took off towards Pluto, is frequently referred to by Wall Street analysts because it contains an error that produces an over-optimistic prediction of where the stock market ought to trade. (It assumes that investors receive the benefit of company earnings in cash, whereas as we all know investors receive only the dividends, while retained earnings are siphoned off to company management through stock option schemes, or eliminated later through “extraordinary charges.”)
Currently, the Fed model calls for an S&P500 Index value of 1513.93, about 27 percent above where it’s actually trading, according to the website Economy.com. An increase in the 10 year Treasury bond yield to 7 percent would cause the Fed model valuation of the market to drop by more than 35 percent, even if company earnings remained unaffected (which of course, they wouldn’t.) Similarly, such an increase would raise 30 year home mortgage rates well above 8 percent, causing an approximately 40 percent decline in the affordable mortgage for any given homebuyer. A serious house price slump, at least in the East and West coast conurbations would inevitably follow.
Even a long term Treasury bond yield of 7 percent, and a real interest rate of 3 percent, would not solve the savings problem. For one thing, the yield would be taxable, while the erosion of the investor’s capital through inflation would not be tax deductible. An investor paying a combined Federal and state marginal income tax rate of 35 percent would receive 4.55 percent net on his Treasury bond holding, while losing 4 percent through inflation. His net real return would be only 0.55 percent; he would thus have suffered an effective tax rate of 82 percent on his 3 percent gross real return. Clearly, such a low net return won’t be sufficient to change behavior by the amount needed. We need to make tax changes to increase the net return from saving.
There are two changes needed to remove the bizarrely high effective tax rates on savings returns. First, invested capital should be indexed, by the Consumer Price Index, so that only real capital gains are chargeable to capital gains tax. Such real gains can then be taxed at ordinary income tax rates, instead of at a special concessionary capital gains tax rate. However, real capital losses must be offsetable against other income; in the example above, the investor in long term Treasuries would receive an offset of 4 percent of his investment against interest income from the bonds, or against other income generally.
Second, dividends must be tax-deductible at the corporate level, and fully taxable to the investor. The current system, of a low tax rate to the investor and no tax deduction to the company, produces a conflict of interest between the company (which pays full corporate income tax, even on income that it pays out in dividends) and the investor, who wants high dividends because they are tax-efficient. Further, this like other tax preferences causes many investors to be drawn into the trap of the Alternative Minimum Tax, giving them huge additional tax-time harassment. This change would increase the net return from saving, and reduce the incentive for companies to play games with their corporate tax bills. It could be paid for by restricting home mortgage interest deductibility, perhaps to a maximum of $10,000 per annum.
The elimination of the Estate Tax as currently planned for 2011, or at least its reduction to a maximum of 20 percent compared to its current level of 45 percent, is also necessary – except for the very rich who avoid it through trust arrangements it acts as a pure tax on capital accumulation and thus on saving.
Even with these tax and interest rate changes, personal saving would remain inadequate, for one very simple reason: the entire U.S. advertising industry is geared towards reducing it. If a single advertising campaign can increase sales of a particular brand of soap powder by a noticeable percentage, then the effect of consumer advertising as a whole, that single campaign multiplied by thousands acting to create product desires in every consumer, must be hugely to increase overall consumption and depress saving. The savings rate in China is estimated to be at least 30 percent compared to the U.S. savings rate of 0.2 percent. Chinese people are not 150 times as thrifty as Americans, and they certainly don’t have 150 times as much disposable income after necessities; however they are subjected even now to only a small fraction of the consumption-oriented advertising that barrages Americans at every waking hour.
It’s probably not practicable to insist on a savings-oriented ad. minute being aired for every consumption-oriented ad. minute – the burden on business would be excessive, and the endlessly repeated advertisements for saving would cause a tsunami of consumer violence against their television sets. However, there is one particularly pernicious form of advertising that has mushroomed only in the last quarter century, that for credit cards.
Thirty years ago, if you considered the financial services sector alone (thus ignoring the advertisements for soap powder and other products) savings-oriented advertising (for local banks, savings and loan associations, etc.) and consumption-oriented advertising (for consumer loans) were probably about in balance. However, since then the S&Ls have disappeared, the market share of purely local banks has dropped sharply, and interest rate ceilings on consumer deposits have been removed, thus greatly reducing their profitability – that’s why you no longer get a free dinner plate when you open a bank account.
Profitability in consumer banking is now concentrated almost entirely on the loan side, in home mortgages, but more especially in home equity loans, automobile loans and credit cards, on all of which products the interest margins, even after debt losses, are very substantial. Hence advertising, both over the air and through direct mail, has gone where the money is, promoting consumer loan products of one kind or another.
It is clear that all this activity in consumer lending is neither good for consumers, nor for their savings rate. Credit cards enable consumers to buy things they can’t afford, removing the natural prohibition against spending money you haven’t got. New credit cards offer attractive interest rates at first, but quickly ratchet rates up to usurious levels, ensuring that consumers who’ve used credit cards excessively are mired in debt that is very expensive to service and that they can’t afford to repay. Consumers who suffer a temporary difficulty, such as a job loss or a medical emergency, no longer have savings to tide them over because they rely on their credit card lines to perform the same function. The steadily rising rates of consumer bankruptcy, even in a lengthy period of economic growth and very low interest rates, are evidence that most consumers who get into substantial credit card debt are unable to manage it.
The appropriate analogy here is tobacco. Like tobacco, credit cards are addictive, a habit very difficult to break, and are in the long term very damaging – in this case to a consumer’s wealth rather than to his health. Like tobacco before the Surgeon General’s Report of 1964, credit card usage is turbo-charged by heavy advertising, much of which offers benefits that are illusory – you cannot in the long run afford a higher standard of living with a credit card than without one.
The solution is thus to ban credit card advertising, as well as advertising for home equity loans, store finance and automobile loans – only first mortgage loans, necessary for home purchase, could perhaps be exempted. Direct mail credit card offers, telephone solicitation and Internet credit card spam would also be strictly prohibited – it is several decades since we allowed tobacco manufacturers to send out direct mail samples of cigarettes.
As well as reducing the direct incitement to incur debt, prohibiting credit card advertising would make banks market themselves on service and deposit rates, thus once more appealing to the income and asset side of the consumer’s balance sheet, and highlighting their most important social function, that of providing a secure home for savings. Credit cards would remain legal, but would have to be sold directly through a bank branch – thus a consumer would be unlikely to accumulate more than 1 or 2 cards. The debit card alternative, in which purchases are debited directly to the consumer’s bank account, would remain freely available and promotable, as today.
No administration is going to undertake such unpopular reforms without being forced to. Fairly soon, the market will provide the necessary compulsion.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.