Sunday, February 8, 2009

The Return to Thrift?

The saving rate in the United States has increased in the past year. From zero or even negative values, the saving rate has now moved into positive terrain. Some have argued that we are witnessing a return to thrift. This may well be the case, but there are several reasons, according to the theory, why we are witnessing an increase in personal saving. First, saving is a forward looking-variable. According to the theory, saving should be high when income is expected to decrease in the future. Thus, what the current figures about saving may be telling us is the gloomy picture that most households have about the future. Second, saving serves not only to offset decreases in income, but also to insure against shocks. In the current economy, people may feel more uncertain about their future income. Consequently, the amount of precautionary saving may have increased. This is particularly true if people cannot rely on borrowing when facing shocks to income. Both the decrease in home equity and the high amount of borrowing that families are already carrying on their credit cards may indeed make further borrowing difficult or not possible. Thus families may be simply making provisions for a more uncertain future.

Uncertainty is not good for the economy as it depresses not only investment but also consumption. Thus, one way to boost consumption is to restore confidence about the economy and about the future (admittedly a difficult task).

But as families go through the hardship of the recession, buy on discount, and try to keep within their budget, there may be some learning about how to consume and save. In the traditional theory of saving, we assume that people make rather complex calculations to determine how much to save. In practice, only a minority of families seems to make plans and even fewer do any calculations to determine how much money to put aside. The future may seem far away and bad events hard to conceive if people have never experienced one. For example, in some of my research work, I find that people are more likely to understand the effects of inflation if they have lived through several inflationary episodes. Moreover, individuals are more likely to plan for retirement if they have witnessed their parents suffering health problems at an advanced age. Thus, the current crisis may end up affecting saving beyond what we expect from the pure theory and these effects may persist into the future.

Some have argued that thrift is a value that should be instilled into children and adults as well. I am not sure we need to be that sanguine. In the area of saving, as in other parts of life, it pays to plan and consider contingencies. That is the recommendation coming from basic economy theory. We can leave it like that!

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