Transcript UK Households - Economics Today

Does it matter if UK Households
no longer save?
Nigel Watson
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Households save when they make a decision to spend less than their current income.
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In the short-run those that save make a choice to lower their standard of living by sacrificing some
consumption.
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Saving is the act of deferring consumption.
• UK individual consumption almost doubled from 1995 to 2009.
• Two factors drove the increase in consumption.
• The first was the rise in disposable income.
• Disposable income measures the income that households have to consume or save, once fixed outgoings,
such as debt interest have been paid.
• The second factor that contributed to our consumer binge was a fall in the savings ratio.
• According to Keynesians this increase in consumption was instrumental in creating the economic
growth we enjoyed during the so-called NICE decade.
• The UK’s saving ratio rose sharply in 2008-2009, because during a recession the proportion of
household income saved normally rises as more is saved for precautionary reasons.
• But the savings ratio dramatically fell back again, decreasing to just 3.2 by the end of 2010.
• This fall in savings was caused by nominal wage increases failing to keep pace with accelerating
inflation.
• During 2011 it is likely that the savings ratio will fall again, as the drop in real
incomes created by inflation will mean growing numbers of households will be
too poor to save.
• Keynesian economists believe that the level of output and employment depends upon the level of
aggregate demand in the economy.
• If spending levels are low, firms will reduce production to prevent stocks rising.
• Falling production reduces GDP and leads to a decrease in demand for labour, creating unemployment.
• Recessions are caused by a lack of demand in the economy.
• Economies that are in recession experience a negative output gap where the current equilibrium level of
GDP is below the economy’s full capacity output level.
• Keynesians refute the classical assertion that the economy is self-regulating, believing that it will stay in
recession unless the government or central bank take action to boost aggregate demand.
• In the UK the government tried to stimulate short-run economic growth by running huge fiscal deficits.
• The Bank of England played its part by slashing interest rates and printing money.
• The UK economy is now growing again but at a very slow rate.
• To create faster growth, other ways of boosting aggregate demand must be found.
• Interest rates are too low to be cut again, and fiscal policy cannot stay so loose
because of our rapidly growing national debt.
• Keynesian economists believe in the paradox of thrift, which is an old-fashioned word for saving.
• According to Keynes, thrift is beneficial for the individual but bad for society.
• Keynes though saving was bad for the economy as a whole as higher levels of saving would lead to a
corresponding fall in consumption.
• Falling consumption would lead to falling aggregate demand, falling output and falling
employment.
• It follows from this that policy makers should reduce the level of saving in order to achieve higher
rates of short-run economic growth.
• The Bank of England’s cut in interest rates to 0.5% which has remained for over a year, has penalised
saving by reducing the interest earned by savers.
• The mandate of the Bank is to conduct monetary policy so that CPI remains within a percentage point of
a 2% symmetrical inflation target.
• CPI inflation which has been above 3% for over a year shows the Bank has not tightened monetary
policy.
• The Bank’s inflation forecasting record is also poor.
• Inflation going forward has always been underestimated.
• Inflation reduces the incentive to save because it compromises the ability of money to act as a store of
value.
• In the past many people saved for precautionary reasons.
• Today this is no longer necessary, as homeowners, for example, don’t need to have cash in the bank to
pay for their mortgage should they be made redundant.
• Instead people who lose their job will have their mortgage paid by the state, although the percentage has
recently been reduced.
• In Britain, income tax is levied on interest income which also reduces the incentive to save.
• Policymakers in Britain and the US have tried to engineer an export-led recovery.
• Central Banks have used policies such as quantitative easing and zero interest rates to depreciate their
own currencies.
• The pound and dollar have fallen against other currencies which has penalised those who have opted to
save in those currencies.
• Austrian economists stress the role played by investment in building sustainable long-term economic
growth.
• Investment in fixed capital increases productivity, enabling the same stock of factors of production to
produce more in total.
• Therefore investment increases the productive capacity of the economy.
• Building new factories and buying new machinery tends to be expensive.
• Therefore, most firms have to borrow some of the money they need to fund capital purchases.
• Commercial banks can only finance loans to firms if they can attract deposits from savers.
• Without saving there can be no investment. Capital formation cannot happen without capital.
• Keynesian commentators have not understood that banks can only lend the loanable funds which they
have on deposit.
• In the boom years some banks like Northern Rock, to compensate for the UK’s low saving ratio, were
able to borrow on international money markets by borrowing from countries like China, where savings
ratios were high.
• This source of finance has dried up as UK banks are no longer viewed as a good credit risk.
• As a result, credit and thus investment levels will stay low in the UK until people start to save again.
• The on-going credit crunch will continue until the UK’s saving ratio picks up.
• Property speculation is an example of what Austrian economists call malinvestment.
• This type of investment does not add to the productive capacity of the economy.
• Borrowing money to speculate on rising property prices will not help the UK economy to lift its full
employment output level.
• Malinvestment of this type creates debt, without any increase in long run
economic growth.
• Table 2 shows that countries such as India and China have persistently out-saved and out-invested
countries such as the UK and US.
• High rates of investment, created by high rates of saving, have created impressive rates of economic
growth in India and China.
• By contrast, in the UK and US investment has been held back by a lack of loanable funds, so that
insufficient saving has restricted investment and growth.
• To create faster rates of economic growth the UK and US will need to save a greater proportion of their
incomes.
• If the savings ratio remains low the banking sector will remain starved of cash and the credit crunch will
continue.
• To create higher levels of investment and long-run growth, the Bank of England must stop holding
interest rates down to an artificially low level.
• In search of short-run economic growth, the Bank of England has tried to encourage consumption, rather
than saving. Very low interest rates have encouraged speculation, asset bubbles, a huge trade deficit and
record levels of household debt.
• Investment, not consumption, is the key to creating meaningful rates of growth, but has been restricted
by a low savings ratio. In turn banks struggle to lend because they cannot attract enough deposits from
savers.
• In the long-run the UK economy needs to save, invest and produce more, and borrow, consume and
import less.
• Economic growth also depends on the quality of the investment. If investment goes towards a new
machine, this should boost our productive capacity. But, if it is lent to a property speculator, it will leave the
economy’s productive capacity unchanged.
• In the UK homeowners that lose their jobs can claim a government benefit called support for mortgage
interest for two years. This benefit prevents homeowners that do not have savings or redundancy
protection insurance from losing their homes in a repossession. Explain how this benefit affect
a. the incentive to save b. the housing market c. the demand for mortgage debt
• In the UK some economists believe that the Bank of England will be forced into a second round of
quantitative easing to help the Treasury to support asset prices, including the price of government
bonds. Explain how a second round of QE might affect the savings ratio.