Wednesday, September 19, 2007

To Consume or to Save: That is the Question

The U.S. economy depends on consumption. Whenever the economy slows, as is the case in late 2007, market analysts ask if consumers will tighten their wallets and purses, or keep spending. Reduced consumer spending can lead to slower growth. If the cutbacks are substantial, recourse to the "R" word, recession, will begin to appear in print and television.

In the same breath, economists and market analysts warn that Americans consume too much and do not save enough. The U.S. runs a current account deficit, its international trade in goods and services, of around $800 billion a year. This sum represents an increase in foreign claims on U.S. assets. The current account deficit has risen sharply over the past decade. The two leading culprits are oil imports and goods from China. The current account deficit is the flip side of a capital account surplus, which means that foreigners are lending the U.S. money or buying U.S. assets to the tune of $800 billion a year. This an imbalance between domestic saving and investment. Americans do not save enough money to finance investment in the U.S. Foreign capital buys U.S. government securities and a wide variety of other real and financial assets. Foreigners now own more than two-fifths of publicly-held U.S. Treasury bonds, up from 15 percent a few short years ago.

This deficit cannot continue indefinitely without severe repercussions. One is a fall in the value of the dollar against other currencies. Between 2002 and 2007, the Canadian dollar has risen from C$1.58 to US$1.01. The euro has risen from 88 cents to $1.39. The same holds for other currencies. Sustained large deficits could precipitate a run on the dollar. Another repercussion is the prospect of inflation from higher prices of imported goods and services. Another is the potential influence foreigners will have on U.S. foreign policy as they continue to accumulate U.S. Treasury securities and other assets.
Many argue that Americans should save more, both for their own well-being and that of the U.S. economy. The rate of return on saving influences the incentive to save. High real interest rates encourage savings. Low rates discourage saving. When Ben Bernanke and the Federal Reserve Board reduced the federal funds rate from 5.25 to 4.75 percent on September 18, 2007, they reduced the return to savers. Recall that former fed chairman Greenspan held interest rates at a low 1 percent for several years, which resulted in savers receiving a zero, or negative depending on inflation, rate on their bank deposits. The biggest losers in this low-interest world were the elderly, whose interest earnings supplement Social Security. The reduction from 6.5 to 1 percent on deposits during Greenspan’s later years at the helm of the fed cut the interest earnings of the elderly by as much as 85 percent. The September 18 reduction reduced the return on saving by nearly 10 percent, again penalizing savers. Investment bankers, home builders, financial analysts, and others are calling for further cuts in interest rates. Who will speak for savers and the elderly?

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