Eco Today - Mar10:ET Master Page 2007 - ASKnLearn

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60 50 40 30 20 10 0 36.0 ’92 37.8 ’93 39.1 ’94 Figure 3: China’s savings ratio in 1992-<strong>2007</strong> (%) 38.4 ’95 37.2 ’96 37.7 37.8 And here’s another one to try: If interest rates are 20% how many years will it take to double a £100 debt? The answer is 3 years and ten months (almost) 3 but most people think it’s a lot longer. 4 Some theory basics If there were no government and no foreign trade then we either consume (C) or save (S) all our income (Y), so Y = C + S. This is from the consumer’s point of view. From the firm’s perspective, all income is either used on paying to produce goods and services, or for investment in capital goods so that goods and services can be produced in the future. So for a firm, Y = C + I, with I 36.6 36.9 37.7 39.3 42.1 46.1 47.5 47.9 49.9 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 Source: http://docs.google.com/viewer?a=v&q=cache:NYzVzgj02gYJ:www.bnm.gov.my/files/publication/conf/hilec2009/01_ slides_zhou.pdf+statistics+savings+ratio+world&hl=en&gl=uk&sig=AHIEtbSNxYMbeSzH3rMdZnYOeva7_6z5QQ&pli=1 Percentage with ‘too much debt’ 40% 35% 30% 25% 20% 15% 10% 5% 0% < 2 years Figure 4: How long to double debt at 20%? < 5 years (correct) 5-10 years > 10 years (widely wrong) Don’t know Refuse meaning investment, the increase in capital stock. It’s not a great mathematical mystery revealed to say that if Y = C + S and Y = C + I, then, by definition, I and S must be equivalent. In other words people save the same amount that firms invest, which is an amazing observation if it means that more saving means that firms invest more. Actually, this causal relationship does not follow. Nor does it mean that more investment will mean that it will make people want to save more. What it does mean is that there is a proportion of income that is not spent, and this will have a major impact on the amount of activity or consumption in the economy. 3. The formula is premium times interest rate to the power of the number of years (x). So it’s 100 x 1.2x then take logs of both sides so x log 1.2 = log 2, and divide both sides by log 1.2. X is 3.801. 4. http://www.oecd.org/dataoecd/34/9/44280581.pdf OECD conference Brazil December 2009, result of independent research by phone of 1000 adults in 80 countries. 5. http://www.mckinsey.com/mgi/mginews/unleashing_ chinese_consumer.asp. Grossly underestimate compounding Impact of savings on growth If people save more then firms cannot sell everything they intended to sell, leaving unsold stock that appears on their accounts as investment. The next year they will produce less (because there are unsold stocks) so there will be less money in the circular flow of income. A rise in savings slows down consump - tion so in the short run it makes the economy look worse off in GDP. Our tendency to spend or save explains the multiplier effect, and the higher the saving the lower the multiplier. But a low multiplier can be a good thing. A large multi plier makes injections have a greater boost on the economy, but in reverse a large multiplier can throw an economy into recession. A small multi - plier means that growth is on a steadier course, and the higher levels of savings keeps consumers more confident, and firms less volatile. It means capital markets are less volatile, and there is less cause for alarm concerning pensions. Savings and the multiplier Savings are a leakage out of the circular flow of income. The more we save, the less money will be spent, earned and respent in the economy, and the multiplier effect is smaller. The lower the marginal propensity to consume, the lower the multiplier. When you consider the size of the multiplier you will earn evaluation marks in your economics exam, so it is good to consider factors such as savings when considering the full impact on any shift in aggregate demand on the price level and real output. You may also argue that changes in total spending cannot be affected by changes in aggregate demand (if the aggregate supply is vertical) so the impact of changes in injections will only impact upon the price level. In the UK household consumption is 65% of GDP, meaning that consumption is a highly significant part of total demand. Discussing the importance of consumption to the UK economy, for example with the contrast of 36% of China’s GDP, is another way to earn evaluation marks. 5 Savings and pensions In your grandparents’ generation, pensions were something to look forward to. Many workers had their income linked to their final salaries, meaning that for the rest of their lives they could earn a good percentage of 16 M ARCH 2010
the amount they got in their last few years of work, linked to average incomes, so that it would not fall in real terms. This is no longer true: 90% of final salary schemes are closed to new members, and many workers are no longer guaranteed income after they retire. Since 1980 pensions have been linked only to the price level, not to average incomes, so with accelerating incomes the gap between wages and pensions grows ever larger. Two-thirds of workers under the age of 30 have no pension at all. In many UK and US firms, the pensions deficit is causing many problems, for example in some car manufacturing plants where the pension bill is already up to 25% of the wage bill. The cost attributed to pensions in a new GM car is $1,120 (2006 figures). 6 <strong>Today</strong> we need to save if we want to be guaranteed a good income when we retire, and living on the state pension alone (£95 a week) would leave you below the poverty line (£115 in 2008). According to research by the govern - ment’s National Savings and Invest - ments, more than half of the UK population (53%) do not save any extra money a month, and of the rest, 90% have an average of just above £7,000. 7 Consumption may fuel growth, but savings prevent us from long-term poverty. In the short term macro - economists may like everyone to spend as much as possible to keep national income up, which will bring short term benefits to income and wealth. Savings bring longer term prosperity to a country, but if they grow too large they stifle the growth in the economy, reducing the size of the multiplier. The imbalances caused by increased household debt have been highlighted as one other main causes of the credit crisis, and this must be addressed if the future is going to avoid ‘the boom and bust’ extremes. One solution is to start raising interest rates, which might slow the pace of the recovery but will stop households from taking out even more debt. Household debt is becoming the trendy credit crisis now the banking system’s credit crisis moves into history. Questions for discussion 1. When household debt grows too large and there is a sudden cut in consumption, the effects can be 6. http://www.bloomberg.com/apps/news?pid=20601101 &sid=agvBuODXiKKs. 7. http://www.nsandi.com/pdf/QSS_Autumn09.pdf. % of average earnings 30 25 20 15 10 5 0 ’78 Source: DWP made less damaging to the economy by a cut in the interest rates by the MPC. Why do you think interest rates were kept high in the 1990s in the Netherlands despite the sharp rise in household debt? Remember that the Netherlands is part of the Euro area. 2. Why are savings anti-cyclical against economic growth in the West and not so in Asia? What do you think the pattern is in Latin America? 3. Why might fixed-rate mortgages make unreliable the prediction of the effect of interest rate changes on consumption? Key terms Figure 5: How much is a state pension worth? 1980 – Link between pensions and earnings cut ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 4. In 2024 the pension age will phase in changes from 60 to 66 for women. This is quite a large jump, and will affect women currently under 46. What effect will this have on the supply of labour and average real wages? Do you think younger people will lose out on jobs to people who stay in work longer as they grow older? What will happen to the quality of labour as the length of the working life increases? Remember that many of your examiners are over 50 before you come to sweeping conclusions! Savings – the amount of current income put aside for future expenditure on goods and services. Savings gap – the difference between actual savings and the amount of savings needed for wealth to grow in line with incomes, estimated to be between £16.5bn and £66bn according to NIESR: http://ner.sagepub.com/cgi/content/abstract/191/1/79. Saving ratio – how much we save on average out of income. Marginal propensity to consume – the amount of any extra income that is spent on goods and services. Marginal propensity to save – the amount of any extra income that is put aside for future purchases of goods and services. The multiplier – the magnified effects on income as money that is earned is re-spent in the economy repeatedly through consumption within the economy. Anti-cyclical – when a variable moves inversely with the economic cycle. Savings as a ratio go up when growth falls in western economies. Pension – a tax efficient source of post-retirement income, part of which the government provides to people who have worked in the UK. Pension gap – the difference between actual pension outcomes and the amount of pensions needed for post-retirement income to grow in line with incomes of people currently in work. M ARCH 2010 17
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