Sunday, April 24, 2005
The penny drops on savings
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

A week ago I launched my alternative election coverage — the things they are not telling you about — and got an encouragingly large postbag on the north-south divide. This week’s second instalment was intended to be about pensions.

I cannot, however, quite carry that off, for two reasons. One is that the Tories have indeed tried to make pensions an election issue, and to a certain extent succeeded. The other is that, important though the subject is, the great risk of an article about pensions is that nobody gets beyond the second paragraph, particularly in bed on a Sunday. Other temptations, such as the omnibus edition of the Archers, are simply too great.

So let me try a different tack. One theme here in recent weeks has been that the economy does not feel as good as it should, given an unbroken run of growth stretching back to 1992, when many of the voters who will be casting their ballots in 11 days’ time were still in short trousers. In fact, as far as consumers are concerned, this has been an unusually fertile period.

Roughly speaking, consumer spending should rise in line with gross domestic product. If we take the period from 1948, GDP recorded a real-terms rise of 308%, consumer spending slightly more, 326%.

In the past few years, however, consumer spending has grown nearly one-and-a-half times as fast as GDP. Since 1997, GDP has risen by 20.7%, consumer spending by 27.2%. In every year under Gordon Brown’s chancellorship consumer spending has outstripped GDP. That has never happened over such a sustained period before.

In this, Britain has been something of a “mini me” to America. Stephen Roach, chief economist at Morgan Stanley, points out that US consumer spending has been growing faster than incomes since 1995.

In Britain there have been some special reasons. The pound’s rise, which occurred just before Labour took office eight years ago, gave consumers the benefit of lower prices while making life more difficult for exporters. Business has been prey to the vagaries of the global economy; consumers have been the main beneficiaries of the low interest rates put in place to see the economy through the world’s vicissitudes. Consumers have also been able to tap into the property boom through equity withdrawal (taking out some of their gains from higher house prices).

Most of all, consumers have been able to spend more because they have saved less. The saving ratio, net saving as a percentage of disposable income, dropped from 9.7% when Labour was elected, in the spring of 1997, to just 5.6% last year. It has been even lower under Labour; the lowest quarterly figure was a mere 3.5%.

When we used to be told sternly that we were living beyond our means, the usual symptom of that was a trade deficit. Sure enough, Britain’s trade deficit in goods ballooned from £12 billion in 1997 to £58 billion last year.

But there is another important sense in which we have been living beyond our means, and this is where we come back neatly to pensions.

Goldman Sachs, in a paper entitled How Big is the UK Savings Gap?, attempts to put a figure on this. The paper, by Ben Broadbent, first estimates how much more we need to save as a nation to bring the current-account deficit (£25.7 billion last year) into balance and maintain the UK’s capital stock — in others words, to invest enough to preserve the economy’s productive capacity.

The answer to that question is that savings need to be about £17 billion a year, or 1.5% of GDP, higher. The story, however, does not end there. Broadbent then looks at what the country needs to be saving to offset the effects of an ageing population.

Because we are getting older, the working-age population is set to decline quite sharply as a percentage of the total, from 63.2% in 2008 (slightly higher than now) to 56.7% in the 2030s.

If there is no response to that now in the form of higher saving, the future will be a lot poorer. The fewer workers there are, and the more dependants, the less well-off everybody will be. Roughly speaking, the population would be 10% a head worse off than in the absence of an ageing population. This can be partly offset by longer working, which will surely be part of the government’s solution when presented with the final recommendations of Adair Turner’s Pensions Commission later this year.

Mainly, however, it will require more saving, perhaps £30 billion a year on top of the £17 billion. Rounded, the savings gap is £50 billion.

That gap is not going to be closed overnight but even a modest increase in savings has a big effect on the economy. The Ernst & Young Item Club, in its new forecast to be published tomorrow, simulates the consequences of an increase in the saving ratio from 5%-6% to 7%-8% of income.

The effect is to reduce consumer spending growth this year and next, to only 1.2% in 2006. Significantly, it would usher in a period in which consumer spending would grow at a slower rate than GDP for several years, breaking the recent pattern.

If savings suddenly shot up by £50 billion a year, of course, the economy would dive into recession. This was Keynes’s famous paradox of thrift: more saving is good but too much more, too quickly, is bad.

Are consumers already starting to adjust? Last week’s soft official retail sales figures for March confirmed the change of mood among British shoppers. For the past two years, in fact, consumer spending has barely outstripped GDP. In the final three months of last year it was weaker.

Why is this? Higher interest rates have played a part, as has the squeeze on real incomes described here recently. But maybe, just maybe, people are starting to get wind of the need to save more. And perhaps, too, the penny is starting to drop that the next few years will not be nearly as good as the last.

PS: Is the game up for us interest-rate doves? Does last week’s shock news that inflation jumped to a seven-year high of 1.9% last month mean we should accept the inevitability of an early rise in rates from the Bank of England? Let me deal first with the seven-year-high bit. While this is true for the new consumer-prices measure now targeted by the Bank, it is emphatically not so for the old target measure, the retail-prices index excluding mortgage-interest payments. Inflation on this measure was 2.4% last month, the same as in January last year. It was higher for 14 months, from November 2002 to December 2003. So we should keep the latest numbers in perspective.

The key point, however, is that the monetary policy committee (MPC) is not in the business of knee-jerk reactions. Inflation is running a little higher than the Bank expected but growth is plainly weaker. The same factor, oil at more than $50 a barrel, goes much of the way to explaining both. Add in the independent weakness of retail sales touched on above, and the case for higher rates is still far from proven.

My sense is that most MPC members will have been quite relaxed about last week’s figures. Two are already in the rate-hiking camp. Some others would join them if the figures warrant it, but are unlikely to conclude we have got there yet. The Bank has just started detailed work on the forecast for its May inflation report. If it concludes that the only thing that has moved the inflation numbers is oil, and that this is not being reflected in higher general inflation (last week ’s MPC minutes noted that pay settlements were steady), it will leave rates at 4.75%.

The risks of a rate hike are bigger than they were. But this particular dove has not yet flown the cote.

From The Sunday Times, April 24 2005

Comments

please answer this question
What were the Classical views about saving?

What is the meaning of Paradox of thrift? Illustrate Paradox of thrift using a diagram.

Posted by: shazia at June 24, 2005 04:52 PM

please answer this question
What were the Classical views about saving?

What is the meaning of Paradox of thrift? Illustrate Paradox of thrift using a diagram.

Posted by: Raza at February 14, 2006 02:37 PM

What is the meaning of Paradox of thrift? Illustrate Paradox of thrift using a diagram and What were the Classical views about saving?

Posted by: aalia at February 17, 2006 05:58 PM

(a) What were the Classical views about saving?
(b) What is the meaning of Paradox of thrift? Illustrate Paradox of thrift using a diagram.

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Posted by: syed khuram abbas zaidi at January 14, 2007 06:10 PM

(a) What were the Classical views about saving?
(b) What is the meaning of Paradox of thrift? Illustrate Paradox of thrift using a diagram.

Posted by: ali jaffri at January 14, 2007 06:12 PM

What were the Classical views about saving?

Posted by: Adeel Iqbal at January 20, 2007 10:54 AM