Saturday February 28, 2009
The paradox of thrift
What Are We To Do
By TAN SRI LIN SEE-YAN
The year 2008 was a disaster for savers. We are taught from young that we should always save. Indeed, it’s a virtue. Stock markets the world over have since plummeted, with the value of investments having fallen by about 50%. The prices of bonds and commercial property have also plunged. Those who diversified to commodities, hedge funds and private equity fared no better. Even those who only saved with banks had to worry about the safety of these institutions, including the brand banks (so much so that governments in many countries have had to step in to guarantee bank deposits). Worse, the value of most people’s main item of wealth – their home – has fallen sharply. This is my 8th recession – I have not seen anything quite like this.
The savers pain can be ascertained from pooled portfolio investments: American mutual funds were reported to have lost US$2.4 trillion in the first 10 months of 2008. The value of US pension funds dropped by US$2 trillion during the 18 months prior to October 2008. This was before Black October 2008 when the Dow virtually collapsed. From its high in October ’07, the Dow took only 503 days to fall 50%, a full 320 days faster than the Nikkei took to fall 50% after the Japanese bubble bust. The Bank of England estimated that close to US$3 trillion was lost in credit-related instruments which dragged down the financial system in the first place. All these losses are just a portion of what was lost worldwide.
Of course, a good deal of these losses fell on many who were able to cope, especially the wealthy. But many others were not so lucky – the elderly and retired, those on pension schemes, fixed income savers, those about to retire, and those with mortgages now higher than the diminished value of their homes. Latest reports indicated that house prices in the US fell 18.5% in ’08, the biggest fall in 21 years. They were told that saving pays in the long-run; most also borrowed on the premise that their house value can only go up. They now wonder why they even bothered. Although not as bad, the overall situation in Asia (including Malaysia) runs along similar lines. Furthermore, interest rates have fallen so very sharply that interest income (which for many are taxed) can no longer support savers in deposits and bonds.
According to Lord Keynes, the root cause of downturns, especially recessions, is insufficient aggregate demand. The rationale is clear. When total demand for goods and services falls, business sales decline. In turn, lower sales lead to cut-backs in production and eventually, workers are laid off. Falling profits and rising unemployment further depress demand, causing a “feed-back loop” very much like what we are seeing now, certainly in the US and Europe. The situation will only reverse when definite action is taken to raise total demand. Very much like Newton’s law at work: objects in a state of motion will remain in motion, unless an external force is applied to stop it. According to Nobel laureate F. Hayek, a contemporary of Lord Keynes, Keynes was “guided by one central idea ... that general employment was always positively correlated with the aggregate demand for consumer goods.” He argued that government should intervene to maintain aggregate demand and full employment, the objective being to smoothen out the business cycle. In recessions, he asserted that governments should borrow and spend.
Output of goods and services in any economy comes from four sources: consumption, investment, government purchases and exports/imports. Any rise in demand can only come from any of these sources (or some combination thereof). In a downturn, strong forces are at work to keep such spending down. Since the US recession started in December 2007, these forces have moved (and spread) so very rapidly that the world as a whole is now in recession. We know that consumers’ confidence in the US, Europe and Japan as well as in Russia and Brazil is now at record lows. When it comes to discretionary spending, whether buying a new house, car or high definition TV, a wait-and-see attitude has set in. From the perspective of the economy as a whole, a recession or downturn is not the best time to save more.
Keynes talks of a paradox of thrift. When households and businesses save more, they are consuming less so that aggregate demand falls which eventually leads to lower national income. This in turn works to deepen the downturn in the short-term. So, saving more now – contrary to a recent Malaysian bank survey’s report that Malaysians are not saving enough – is not a good idea. Malaysians are already among the world’s high savers. In 2007, gross national savings accounted for 39% of GNP and expected at 38% or thereabouts in 2008. In contrast, American savings turned negative for one quarter in ’05 and have since been estimated at about 1% of disposal income in ’08. The British and Japanese saved about 2½% and squirrel-like Germany, 11%.
Most economists (including myself) would regard saving more now undesirable. In the context of a global recession, governments would rather people consume more. This is easier said than done. That is unlikely to happen without a hard “push” when most households are uncertain about the future outlook (regarding jobs). The tendency (especially in Asia and now, even in the US) is to save more, even though their recent experience at holding on to their wealth is far from encouraging. Keynes once remarked: “Whenever you save five shillings, you put a man out of work for the day”.
Hence, governments are keen to “stimulate” and do their darnest to get consumers and businesses sustain their spending power.
It is said that recession could well be the “penance for past profligacy”. Yet high savings and low private debt have not protected Germany and Japan from recession. Indeed, prudence has not spared them. The trouble is that they had thrived (and accumulated surpluses) on the back of the persistent spending of others especially the US and Europe. When these nations started to cut back because of recession, Japan and Germany suffered badly as a consequence. Japan’s exports fell by 45.7% this January, the sharpest fall in more than 40 years. Germany, Europe’s largest economy, posted a sharp GDP contraction in late ’08 as crucial exports collapsed.
The lesson: both these persistent surplus nations had become too reliant on exports and investments to drive their prosperity. When foreign orders contracted sharply, they went into a tailspin. Technically, both Japan and Germany should still have immense capacity to drive domestic demand. Unfortunately, their instinct for saving hardens in a recession.
Japan’s “lost decade” of the 1990s offers valuable lessons in managing the risk of deflation. Indeed, it provides an insight into how thrift can take hold of consumption with disastrous impact. As its economy weakened, consumers are not ready to spend more as they see their wealth shrink and begin to worry more about jobs.
Firms can also become big savers in uncertain times. For Japan, inflows of capital strengthened the yen, squeezed profits on exports and made businesses more reluctant to invest. Between 2001 and 2007, per capita consumer spending was reported to have risen by a mere 0.2%. With recession spreading globally, Japan’s economy is now on a free fall as domestic consumption can no longer be relied upon to pick up the slack. Part of this reflects widespread distrust of the Japanese pension and banking systems. Its aging population is not helping consumption either. Fears of a second lost decade now permeate Japanese society.
Global recovery requires a fundamental shift in attitudes worldwide to facilitate multilateral adjustment: “shopaholic” deficit nations (notably US) will need to save a bit more, while surplus nations (especially Japan, although Germany and China appears to be starting to spend more) need definitive and massive efforts at stimulating aggregate demand in a very effective way.
Japan, Germany and China need to change their mindsets that demand has to come from somewhere else (traditionally US), when their own domestic economies should be the locomotive. This would require changing the basic parameters of each of the country’s comfort zone.
·A former banker, Dr Lin is a Harvard educated economist who now spends time promoting the public interest.
The paradox of thrift
What Are We To Do
By TAN SRI LIN SEE-YAN
The year 2008 was a disaster for savers. We are taught from young that we should always save. Indeed, it’s a virtue. Stock markets the world over have since plummeted, with the value of investments having fallen by about 50%. The prices of bonds and commercial property have also plunged. Those who diversified to commodities, hedge funds and private equity fared no better. Even those who only saved with banks had to worry about the safety of these institutions, including the brand banks (so much so that governments in many countries have had to step in to guarantee bank deposits). Worse, the value of most people’s main item of wealth – their home – has fallen sharply. This is my 8th recession – I have not seen anything quite like this.
The savers pain can be ascertained from pooled portfolio investments: American mutual funds were reported to have lost US$2.4 trillion in the first 10 months of 2008. The value of US pension funds dropped by US$2 trillion during the 18 months prior to October 2008. This was before Black October 2008 when the Dow virtually collapsed. From its high in October ’07, the Dow took only 503 days to fall 50%, a full 320 days faster than the Nikkei took to fall 50% after the Japanese bubble bust. The Bank of England estimated that close to US$3 trillion was lost in credit-related instruments which dragged down the financial system in the first place. All these losses are just a portion of what was lost worldwide.
Of course, a good deal of these losses fell on many who were able to cope, especially the wealthy. But many others were not so lucky – the elderly and retired, those on pension schemes, fixed income savers, those about to retire, and those with mortgages now higher than the diminished value of their homes. Latest reports indicated that house prices in the US fell 18.5% in ’08, the biggest fall in 21 years. They were told that saving pays in the long-run; most also borrowed on the premise that their house value can only go up. They now wonder why they even bothered. Although not as bad, the overall situation in Asia (including Malaysia) runs along similar lines. Furthermore, interest rates have fallen so very sharply that interest income (which for many are taxed) can no longer support savers in deposits and bonds.
According to Lord Keynes, the root cause of downturns, especially recessions, is insufficient aggregate demand. The rationale is clear. When total demand for goods and services falls, business sales decline. In turn, lower sales lead to cut-backs in production and eventually, workers are laid off. Falling profits and rising unemployment further depress demand, causing a “feed-back loop” very much like what we are seeing now, certainly in the US and Europe. The situation will only reverse when definite action is taken to raise total demand. Very much like Newton’s law at work: objects in a state of motion will remain in motion, unless an external force is applied to stop it. According to Nobel laureate F. Hayek, a contemporary of Lord Keynes, Keynes was “guided by one central idea ... that general employment was always positively correlated with the aggregate demand for consumer goods.” He argued that government should intervene to maintain aggregate demand and full employment, the objective being to smoothen out the business cycle. In recessions, he asserted that governments should borrow and spend.
Output of goods and services in any economy comes from four sources: consumption, investment, government purchases and exports/imports. Any rise in demand can only come from any of these sources (or some combination thereof). In a downturn, strong forces are at work to keep such spending down. Since the US recession started in December 2007, these forces have moved (and spread) so very rapidly that the world as a whole is now in recession. We know that consumers’ confidence in the US, Europe and Japan as well as in Russia and Brazil is now at record lows. When it comes to discretionary spending, whether buying a new house, car or high definition TV, a wait-and-see attitude has set in. From the perspective of the economy as a whole, a recession or downturn is not the best time to save more.
Keynes talks of a paradox of thrift. When households and businesses save more, they are consuming less so that aggregate demand falls which eventually leads to lower national income. This in turn works to deepen the downturn in the short-term. So, saving more now – contrary to a recent Malaysian bank survey’s report that Malaysians are not saving enough – is not a good idea. Malaysians are already among the world’s high savers. In 2007, gross national savings accounted for 39% of GNP and expected at 38% or thereabouts in 2008. In contrast, American savings turned negative for one quarter in ’05 and have since been estimated at about 1% of disposal income in ’08. The British and Japanese saved about 2½% and squirrel-like Germany, 11%.
Most economists (including myself) would regard saving more now undesirable. In the context of a global recession, governments would rather people consume more. This is easier said than done. That is unlikely to happen without a hard “push” when most households are uncertain about the future outlook (regarding jobs). The tendency (especially in Asia and now, even in the US) is to save more, even though their recent experience at holding on to their wealth is far from encouraging. Keynes once remarked: “Whenever you save five shillings, you put a man out of work for the day”.
Hence, governments are keen to “stimulate” and do their darnest to get consumers and businesses sustain their spending power.
It is said that recession could well be the “penance for past profligacy”. Yet high savings and low private debt have not protected Germany and Japan from recession. Indeed, prudence has not spared them. The trouble is that they had thrived (and accumulated surpluses) on the back of the persistent spending of others especially the US and Europe. When these nations started to cut back because of recession, Japan and Germany suffered badly as a consequence. Japan’s exports fell by 45.7% this January, the sharpest fall in more than 40 years. Germany, Europe’s largest economy, posted a sharp GDP contraction in late ’08 as crucial exports collapsed.
The lesson: both these persistent surplus nations had become too reliant on exports and investments to drive their prosperity. When foreign orders contracted sharply, they went into a tailspin. Technically, both Japan and Germany should still have immense capacity to drive domestic demand. Unfortunately, their instinct for saving hardens in a recession.
Japan’s “lost decade” of the 1990s offers valuable lessons in managing the risk of deflation. Indeed, it provides an insight into how thrift can take hold of consumption with disastrous impact. As its economy weakened, consumers are not ready to spend more as they see their wealth shrink and begin to worry more about jobs.
Firms can also become big savers in uncertain times. For Japan, inflows of capital strengthened the yen, squeezed profits on exports and made businesses more reluctant to invest. Between 2001 and 2007, per capita consumer spending was reported to have risen by a mere 0.2%. With recession spreading globally, Japan’s economy is now on a free fall as domestic consumption can no longer be relied upon to pick up the slack. Part of this reflects widespread distrust of the Japanese pension and banking systems. Its aging population is not helping consumption either. Fears of a second lost decade now permeate Japanese society.
Global recovery requires a fundamental shift in attitudes worldwide to facilitate multilateral adjustment: “shopaholic” deficit nations (notably US) will need to save a bit more, while surplus nations (especially Japan, although Germany and China appears to be starting to spend more) need definitive and massive efforts at stimulating aggregate demand in a very effective way.
Japan, Germany and China need to change their mindsets that demand has to come from somewhere else (traditionally US), when their own domestic economies should be the locomotive. This would require changing the basic parameters of each of the country’s comfort zone.
·A former banker, Dr Lin is a Harvard educated economist who now spends time promoting the public interest.