Wednesday, November 26, 2008

The Long Run View

So the whole economy is supposedly collapsing, right?  Is there any reason to suspect that in the end this could be a good thing?  Yes, if the current issues represent a fundamental shift towards a higher rate of savings.

Following the whole sub-prime financial meltdown, banks and financial institutions got scared and stopped lending. The real economy slowed down as firms couldn't get lines of credit to make payroll or loans to open new offices, and you couldn't get cheap credit anymore to buy a new car or house.  This slow-down has spooked everyone (like you) into doing what? Saving more. Now, rather than taking that vacation, people are paying down credit card debt.  Rather than buying a new car, they are putting that money aside in case they lose a job.  So the rate of savings is going up.

In our basic textbook model of long-run growth, there is an optimal level of savings.  That is, there is a savings rate that maximizes the long-run level of consumption (fun stuff like food and Wii's and princess movies).  This savings rate is usually referred to as the "Golden Rule" level of savings (as in, you should save at the optimal rate so that your children will have high consumption).   The Golden Rule savings rate, in the simplest form, says that the savings rate should be equal to the ratio of (Capital Income/GDP). 

In the U.S., the ratio of Capital Income to GDP is historically around 30%.  That is, of all the output we produce, 30% of it is paid out to the owners of the machines, land, and factories that produce the stuff we like to consume.  If you own an S&P index fund, you own capital, and therefore your dividends (for example) are part of this 30%.   The other 70% of GDP, roughly, is paid to labor.  That is, it is paid to you in the form of wages.

So the Golden rule says that the optimal savings rate is about 30%.  What is the effective savings rate in the U.S. over the last 10 years?  Somewhere around 14-17%.  (You've probably heard that the savings rate is negative or less than 5%.  That's the personal savings rate.  What we care about is the overall savings rate, which includes all forms of corporate investment).   So we are well below the Golden Rule savings rate in the U.S..

Now IF the current economic situation means that people have fundamentally altered their savings behavior and the overall savings rate goes up to closer to 30%, then in the long run we will be better off.  How much better?  Well, in a really rough calculation, having the savings rate go from 15 to 30% would generate nearly twice as much consumption in the long-run as we have now.  And that is ignoring any additional growth in productivity between now and then.  Even if the savings rate only goes up to 20%, this represents a gain in long-run consumption of nearly 60%. 

So in the long run, an increase in the savings rate is the right thing to happen.  We'll all enjoy (and our kids and grandkids will really enjoy) higher consumption thanks to us saving more.  Ideally, we would gradually increase the savings rate over time, avoiding the current drop in economic activity.  However, we've all basically decided to jack up our savings all at once, and that puts the brakes on current economic activity. 

But, in the end, IF we sustain this savings rate, we'll all be better off.  It's just a tough period of adjustment to get there.  So ask yourself this:  would you trade two years of low economic growth and high unemployment (around 9%) for a doubling of your consumption over the rest of your life (and more importantly, your kids lives)?

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