Much ink has been spilled recently bemoaning the sudden rapid increase in U.S. households’ saving rates. From an abysmal low of -0.5% in January of 2006, the savings rate has rocketed up to 6.9% in May. Many commentators fret that the sudden increase in savings will offset an equal amount of consumption, thereby lowering overall GDP. At first glance this worry seems unwarranted. Why? Because of the way we define GDP, which is familiar to anyone who has taken an introductory class in economics as:
Y = C + I + (X – M) + G
Where Y = GDP, C = Consumption, I = Investment, X = Exports, M = Imports, and G = Government expenditures.
That’s fine and dandy, but where, you ask, is savings? Ah, it’s buried deep in the “I” portion of the equation. The usual assumption is that any money saved by households will be lent out to businesses for investment through financial intermediaries like banks or the bond market. In other words, savings will roughly equal investment.
Yet if that is true, any decrease in “C” will be offset by an equal increase in “I”, thereby keeping GDP flat. It’s like a see-saw, where one end is consumption and the other investment. No matter how high or low one end goes, the center will stay at the same level.
Then why are so many market commentators worried about the sudden rise in savings? Because of a flaw in the assumptions undergirding the GDP calculation.
The problem comes in when we try to convert savings into investment. Most of the time, the rough approximation that one will equal the other holds. However, there are circumstances when the savings can get stuck in the intermediaries who are supposed to convert them into loans to businesses for investment: when the intermediaries themselves need the savings to survive. In other words, during a financial crisis.
And that is exactly where we find ourselves now. Most commercial banks are technically insolvent and fighting for their very survival. Any additional savings deposited in those banks are not being lent out, but instead set aside to absorb expected future losses on residential and commercial real estate loans, lines of credit, and a host of other loans extended over the past few years that will probably never be repaid. These dollars have effective “disappear” from the economy, and, since they are not lent out to businesses for investment, won’t offset the decline in consumption. This will lead to an unwelcome outcome: a (further) decline in GDP.
This leads to a somewhat surprising conclusion: the better place for us to park our money is not in the bank, but in government bonds. Why? Because any money the government borrows is likely to be spent, thereby raising the “G” portion of the GDP calculation in an equal amount to the decrease in “C,” thereby keeping GDP level. In other words, the government should assume the role of bank that the actual banks are refusing (or unable) to play.
Instead, though, our government is propping up the very institutions, banks, that are failing utterly and completely at their job: transferring money from savers to businesses. By providing FDIC guarantees to banks’ bond issuance, TARP, and a host of other federal bailout measures, the government is, in effect, subsidizing its competition! Instead of borrowing money from the Chinese, Saudis, and the rest of our foreign creditors to plow money, through TARP, into commercial banks so that they will be able absorb future losses, the federal government should instead borrow money from us, the newly-thrifty savers of the U.S., and spend that money to help keep GDP neutral (or perhaps even positive).
Many readers are likely to say “The government has no idea how to allocate capital efficiently. All we’ll get is a bunch of pork with a load of debt to pay off later.” To that Erasmus replies: That’s probably true, but it’s STILL better than what we’re doing now! We’re still getting the load of debt (money we borrowed from foreigners to in turn lend to the insolvent banks through TARP), but with no corresponding increase in GDP because the money we are giving the banks is getting stuck inside their vaults. In effect, we’re paying for “I” that has already occurred. The money that the banks lent out before the onset of the financial crisis (and stopped lending) has already been spent by those who borrowed it. It was included in previous years’ GDP calculations. Paying for it again, as we’re doing now, is not going to increase GDP by a single penny.
Sadly, the federal government has decided to prop up the incompetent and, at this point, useless banks rather than do what it should have done from the outset: allowed the incompetent banks to fail and take over their role as financial intermediary between savers and businesses until nimbler, more prudent (and mostly smaller) banks could fill the void. Because of this choice, we are likely to see deeper (and unnecessary) declines in GDP due to the “disappearance” of billions of dollars, our new savings, as they get sucked into the black hole that is our banking system.
Disclosure: No holdings in any banks or financial services companies.