Gross Domestic Product (GDP) grew by 1.9 percent in the first quarter 2012, down from a 3 percent increase in the fourth quarter 2011. Since the end of the recession—a span of eleven quarters—the growth rate of GDP has averaged 2.4 percent. Over the same eleven quarter period after the end of the 1981-82 recession, GDP growth averaged 5.5 percent. What accounts for the slow recovery of the most recent economic downturn? One possibility is the country is entering into a period of less than robust growth due to the anemic savings rate over the past thirty years.
According to the Solow Growth-Model, long-term economic growth comes from a country’s willingness to forego current consumption (i.e. save) in order to enjoy higher future consumption. The increased savings is used to invest in education, technology, and capital-deepening. Over the past thirty years the United States—and much of the industrial world—has done the opposite. Americans have increased their current consumption at the expense of future consumption.
The chart above shows the US savings rate as a percent of income. Since 1970 the trend-line for the savings rate has fallen—though it has increased somewhat since the past recession. Between 1970 and 1989 the annual savings rate averaged 9.1 percent; compared to an average of 4.5 percent between 1990 and 2011.
Why has the savings rate fallen over this time? Two suggestions: (1) defined benefit pension plans, which became standard after the Second World War; and (2) the two asset price bubbles of the past twenty years—tech stocks and housing—created by the loose monetary policy of the Federal Reserve.
In theory, defined benefit and defined contribution pension plans are equal. The former plan provides high rewards, but at high costs; while the latter provides lower costs but with fewer guarantees. One downside of defined pension plans is it reduces the incentive for workers to save for their own retirement—especially when someone else is responsible for making the contributions.
The problem in the United States is most workers want the rewards of the defined benefit plan but pay the costs of a defined contribution one. The US economy in the 1950s and 1960s allowed workers and employers this option. Back then a GM or Ford employed hundreds of thousands of workers and had to finance relatively few retirees. In addition, these firms didn’t face global competition. As a result, firms put up limited resistance to labor demands for generous retirement plans. GM and Ford could charge a few extra dollars for a car to finance those workers who were retired. As well, to guarantee a dollar in future pension didn’t mean they had to put a dollar in an account right then. They could contribute, say only eighty cents, because pension plans could invest that contribution and earn interest, which would be available in the future. Another factor was life-expectancy. In the post-war period, it was around sixty-five years of age. Thus workers who retired at sixty could be expected to receive on average benefits for only a few years.
Times are different today. Now a GM and Ford have four or five times as many retirees as workers. A fully finance pension plans adds thousands of dollars to the cost of every car. With global competition, it is difficult for the carmakers to pass these costs on to the buyer. Secondly, life-expectancy has risen to near eighty years of age. This means the average retiree will receive benefits for twenty or more years, putting additional pressure on pension funds. What has happened is the money put into pension funds today are not being invested, they are being used to cover the pensions of current retirees.
The second possibility lies with the Federal Reserve’s monetary policy over the past couple of decades, one which created two asset bubbles. Americans saved less during this period because they assumed (wrongly as it turned out) that prices would continue to rise and would make up for any deficiency in their savings accounts. The chart which plots the savings rates also does the same the federal funds rate. As it is with the savings rate, there is a downward slope in the fed funds trend-line.
This in a way contradicts basic economic theory, which suggests a negative correlation between the savings rate and interest rates. When savings is low—i.e. the supply of loanable funds is limited—the price of money (interest rate) should rise. If savings is high, the price should fall. It should be pointed out that the federal funds rates used are in in nominal and not real rates. Nominal rates equal the real interest rate plus expected inflation. The growth rate of the price level since the late 1980s has diminished greatly from the high rates of the 1970s.
Ben Bernanke and Alan Greenspan argue that the reason for the low rates—despite the equally low US savings rate—was the world-wide savings glut. In a global economy, the Fed rightly needs to take into account more than just domestic economic conditions. One such condition should be how the global savings is being invested. A large portion of the money saved by the Chinese is going into US Treasuries. This would be okay if the federal government was running deficits to finance projects designed to promote long-term economic growth. Rather it is a situation where a growing part of the budget is going into transfer payments. The graph below charts the size of the federal debt since 1990—which has increased by 360 percent over the past twenty-one years.
A large portion of the increase in federal spending was for outlays to Social Security and Medicare, which increased 250 percent since 1990. Like with the private sector, the federal government has promised retirees a defined benefit retirement program in the form of Social Security and Medicare. The problem is politicians have tried to finance it as if it was a defined contribution plan. In addition to guaranteed lifetime monthly checks, the federal government provides generous cost-of-living raises. At the same time they are unwilling to require current workers to pay the full cost of such future promises. The federal government made things even worse when it reduced employee contributions to Social Security a couple of years ago as a short-term solution to stimulate consumption. When interest on the debt and other income security payments are included, a large portion of the federal budget goes to transfer payment designed to help consumption—not savings. In 2011 these outlays represented 62.9 percent of total federal government outlays.
This is not to say that the lack of savings is the only reason for the lackluster economic growth over past few years, just that it is a factor. The US has enjoyed a two decade reprieve from reality, one which permitted them to consume like drunken sailors. The thinking was they didn’t need to worry about the future because the rising stock market and housing prices would provide for their retirement. There is an old saying that one reaps what he sows. The US may now be realizing the consequences of their unwillingness to adequately save for the future.