The Paucity of Savings and the Global Financial Crisis

Robert Skidelsky and Paul Davidson are both renowned Keynesian scholars. Skidelsky has recently written a new book on Keynes (Keynes: The Return of the Master, Allen Lane, 2009) as has Davidson (The Keynes Solution, Palgrave Macmillan, 2009). Both books appear to have been inspired—if that is the right word—by the GFC.

Both Skidelsky and Davidson see relevance in Keynes, particularly in his emphasis on uncertainty, in understanding the cause of the GFC and in putting in place measures to mute future financial and economic downturns. Not surprisingly they see more involvement by regulators and government as being the answer.

Skidelsky and Davidson are not alone. For example, Nobel Prize winner Paul Krugman (The Return of Depression Economics and the Crisis of 2008) writes:

Once again the crucial question of how to create enough demand to make use of the economy’s capacity has become crucial. Depression economics is back … The answer, almost surely, is good old Keynesian fiscal stimulus … Maynard Keynes—the economist who made sense of the Great Depression—is now more relevant than ever.

There is almost joy in it.

Keynes (The General Theory) laid great stress on the role of expectations, based on flimsy evidence of what an uncertain future might look like, in guiding investment decisions. This, he argued, made the system sensitive to news and susceptible to collapse when valuations became overstretched. Skidelsky, Davidson and other Keynesian economists are undoubtedly right, in my view, in saying that this was a significant stride forward in explaining why economic fluctuations might at times be acute; and why falls in interest rates might not be sufficient to cause an immediate rebound in investment once expectations become moribund. However, it does not explain why particular crises arise nor does it point to appropriate remedial action.

Capitalist economies are unstable. They go through periods of boom and bust. Did this account for the GFC? In a sense, of course it did. But it is puerile or politically opportunist (or both) to think this provides an adequate explanation and that compromising capitalism with further doses of government intervention is the key to remedying the situation.

The problem with saying, in 2008, that “economies have turned down so let’s turn to Keynes”, is that the world immediately preceding the GFC was far removed from the world Keynes saw developing when he was looking ahead in the 1930s. Keynes saw two faults in laissez-faire capitalism: its tendency to generate booms and busts; and its inability to maintain full employment because of falling investment opportunities (as the capital stock became abundant) and rising savings (as societies grew richer).

On the first, guilty as charged you might say; but c’est la vie, energising and enervating capitalism is the only system that will ensure our prosperity and freedom. Keynes’s proposal that we control it by socialising investment is hardly ever referred to by Keynesians because they know it is silly. On the second, Keynes entered the precarious and tenuous world of prophecy.

I recall a futuristic television series back in the late 1960s or early 1970s. It had clunky telephones connected inside low-slung aerodynamic-looking cars—not a mobile phone in sight. The near future is uncertain, the far future unknowable. If one is in the business of predicting the far future, it is best to make it far enough ahead—out of a reasonable lifetime—so that it will not bring ridicule when it inevitably proves to be badly astray.

Keynes in 1936 believed that abundance was within our grasp (The General Theory, 16(iv)):

I should guess that a properly run community … ought to be able to bring down the marginal

efficiency of capital … to zero within a single generation … if I am right in supposing it to be comparatively easy to make capital goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of the objectionable features of capitalism.

This thinking was more poetically expressed in an earlier essay published in 1930 (Economic Possibilities for Our Grandchildren). Keynes foresaw a world 100 years into the future whose wants would be easily satisfied by an abundant capital stock:

‘we shall endeavour … to make what work there is still to be done to be widely shared as possible. We shall once more value ends above means and prefer the good to the useful. We shall honour those who can teach us to pluck the hour of the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, the lilies of the field who toil not, neither do they spin.’

Thankfully Keynes is proving to be on a par with most prophets: extremely poor at it. The brave new world he foresaw might have been pleasing to him and his Bloomsbury chums; to most of us, I suspect, it would be insufferable. But this is by the way. The substantive point is that want and scarcity still abound and industrial societies, on the whole, show no inclination to over-save; in fact the reverse is the case. Keynes’s “fundamental psychological rule of any modern community that, when its real income is increased, it will not increase its consumption by an equal absolute amount, so that a greater absolute amount must be saved” has proved to be not so fundamental after all.

There has been a steep decline in household savings in recent decades. Recent OECD figures show that the weighted average saving rate for the eighteen OECD countries whose figures go back that far fell between 1992 and 2007 from over 10 per cent to around 4 per cent. Most importantly, the household saving rate in the USA fell from 7.3 per cent in 1992 to 1.7 per cent in 2007 (Australia’s fell from 5.1 to 2.1 per cent, the UK’s from 11.7 to 2.2 per cent). Of the eighteen countries only France and Germany had a household savings ratio that had not fallen over the period. Compounding the decline in household saving has been a steady diet of budget deficits (in other words, government negative saving) across most of the OECD member countries. Investment has been maintained only by sucking in imports and savings from China, other Asian economies and the Middle East.

This isn’t the world of falling demand that Keynes foresaw. As industrial countries have become richer so they have consumed proportionately more, not less. Under-saving has become the problem. It is a bit rich in these circumstances for Skidelsky to trumpet the return of the “master” from the past as the key to understanding the GFC, when the master’s vision of the future was so badly astray. Pumping demand in a new era of over-consumption might not be the best remedial measure to take. It is a bit rich too, to advocate Keynesian fiscal stimulus in an industrial world sated by decades of government deficit financing. Effectively, we have had almost unremitting Keynesianism. That has been part of the problem; it is hardly likely that larger doses will be part of the cure.

Savings provided the wherewithal for capital investment and economic progress for Adam Smith and some of the later classical economists, and those that followed them, before macroeconomics was rewritten by Keynes. It is their economics rather than Keynes’s that has perhaps come into its own again. A classical remedy of avoiding artificial boosts to demand—balancing budgets (measured over cyclical up and down years) and encouraging production and saving—would seem a better fit for the world we now live in.

Why has saving declined so steeply, and what part might this have played in causing the GFC?

Millions of words have been written in short order to ferret out the detail of the GFC. What was (or were) the pivotal cause(s) of the GFC? Was it imprudent bank lending; or securitisation and derivative trading; or Greenspan’s loose monetary policy; or global imbalances; or those fellow travellers, reckless risk-taking and unbridled greed? Was it one of these in particular, or a combination of all of them, or of some of them? As debate can still rage over what caused and prolonged the Great Depression, it seems doubtful we will ever have agreement on what caused the GFC.

One of the more imaginative views from the Left is in Graham Turner’s The Credit Crunch (Pluto Press, 2008). He suggests that the GFC stemmed from corporations boosting their profits at the expense of workers by shifting production offshore; with complicit governments inducing rises in housing prices to keep the workers preoccupied—I suppose rather like pornography was used by the Party in Oceania (in Orwell’s Nineteen Eighty-Four) to keep the proles docile and otherwise engaged.

There are fairies at the bottom of the garden in David Korten’s Agenda for a New Economy (Berrett-Koehler, 2009), in which Wall Street, market fundamentalism and free trade are identified as culprits, with an attendant “hope” that Obama will make a speech promising, among other things, that “we will build our infrastructure around the model of walkable, bicycle-friendly communities”, with local and national food and energy (renewable of course) independence while, at the same time, giving “all people … the opportunity to own their own house … to assure access by every person to quality health care, education and other essential services … progressive wage and benefit rules”, and so on in the same vein; and all without Wall Street, market capitalism and free trade. Korten despondently thinks his hope will be unfulfilled. We can but hope he is right.

There has been nothing like the GFC in our lifetimes to bring Keynesians or socialists out of their hibernation (induced by the demonstrated failure of socialism), or to convert an erstwhile economic conservative prime minister into a social democrat.

On a more informed note, Ross Garnaut (The Great Crash of 2008, MUP, 2009), fresh from his climate task, tells us that a book was needed “that pulled it all together”. His four-part account of the GFC—booms and panics, global imbalances, clever money, and greed—though by no means novel, provides a comprehensive and balanced take on the GFC. Where Garnaut, in my view, takes a step out of the usual porridge of ideas is to counter the Bernanke view (“The Global Savings Glut and the US Current Account Deficit”, Sandridge Lecture, April 2005), that a glut of savings in the Asian world caused global imbalances, by effectively saying that it takes two to tango. He refers to the “dearth of savings”, in what he calls the “Anglosphere”, as contributing to global imbalances. This provides a launching point for exploring further what role this dearth of savings may have played in causing the GFC.

What I will call the paucity of saving, and across most OECD countries, not just the Anglosphere, did not alone cause the GFC. As with many disastrous events, there was a series of contributory factors working together. But the paucity of saving was an important backdrop to what occurred and, almost certainly, was (and continues to be) a more fundamental fault line than any of the factors commonly suggested as being pivotal in causing the GFC. This can be appreciated by considering those factors: lending, securitisation and derivatives; then Greenspan’s loose monetary policy and global imbalances; and, finally, risk-taking and greed.

Whatever else was underlying or complicit, the GFC stemmed from US banks making poor quality (sub-prime) housing loans; lots of them. Poor quality lending for housing was occurring elsewhere, particularly in the UK, but size matters and the substantive problem originated in the USA. “Clever money”, as Garnaut called it, gave us the GFC by making the problem systemic and widespread. Loans were securitised. Fannie Mae and Freddie Mac were willing purchasers and on-sellers of these securities, which unsurprisingly, given the quality of the assets underlying them, were junk or near junk. Investment banks, and their financial engineers, diced and spliced and created derivative instruments out of these securities, obscuring their risk, and magnifying their spread among institutions in the USA and elsewhere. Rating agencies were fooled into giving inappropriate ratings and, therefore, into giving false comfort.

Having said that clever money gave us the GFC, it is still true to say that it was of second order. Securitisation and derivatives don’t compromise safety, if the underlying assets are safe. Why were the underlying assets unsafe? The Community Reinvestment Act in the USA undoubtedly played a part by pressuring banks into lending to poorer communities. Securitisation may have played a part by getting the risk off the lending banks’ books, potentially making lending practices more cavalier. One way or another, the blame usually comes back to irresponsible lending, and so far as some borrowers are concerned: “the banks made me do it”. But banks don’t haul borrowers in through the door and make them sign loan contracts.

Banks were scrambling for funds. Where banks used to fund their lending from their own deposits, this was no longer possible. Securitisation and the creation of exotic derivative instruments can, in fact, be thought of, at least in part, as “plumage” to attract savings in an industrial, and particularly US, world of scarcity. There was an evident and endemic paucity of saving. The counterpart of a paucity of saving is a spending-and-borrowing culture. It was this, arguably, that was as fundamental to the growth of default-laden loans as the behaviour of banks was in satisfying the demand for them. Greenspan was also playing his part. As Federal Reserve Chairman during the aftermath of the 2001 “tech wreck” and then 9/11, Greenspan presided over an extended period of accommodating (“loose”) monetary policy designed to keep the US economy afloat. The funds rate was brought down from 6.5 per cent at the end of 2000 to as low as 1.0 per cent in mid-2003 and did not get back to a more “normal” or “neutral” rate of 4.5 to 5.0 per cent until 2006. (See Thomas E. Woods Jr’s recent book Meltdown for a great libertarian read on the damaging impact of allowing governments or central banks to control the money supply.)

Loose monetary policy, as with any currency debasement, tends to increase price inflation of goods and services or of assets (or both) as money is borrowed and spent. In this case, goods and services inflation was largely contained by low-priced imports, which had a counterpart in a worsening US trade balance. Other things being equal, this loose monetary policy would have been punished by a falling US dollar and rising US interest rates, as the price of attracting overseas capital in order to offset the trade imbalance. But again, in this case, most importantly China, but also Japan, oil exporters, and others, were willing holders of US assets at the prevailing exchange and interest rates. There was no price to pay. As a result asset prices in the USA, particularly residential property prices, grew strongly.

The question is what part this played in the GFC. It played a part. When assets fall sharply in price they usually don’t do so from a depressed level. But there is no right level of assets prices. We can’t say that if property prices double they are bound to fall. They will fall if a substantial number of those who have borrowed to purchase property are unable to service the debt; usually because of changed circumstances. In this case, large numbers of housing borrowers simply couldn’t service the debt, almost from the start. The problem could not have existed to nearly the same extent without Greenspan, or for that matter without China. But, with a higher propensity to save, the effect of loose monetary policy would not have been so acute and, in part, it again comes back to a paucity of saving. The preparedness of so many to incur unsustainable debt and (in general) to spend and borrow rather than to save was complicit in the course of events. Why the propensity to save has fallen over recent decades is therefore an important question to address. Reckless risk-taking and greed may come into play; though not, I suggest, the kind of risk-taking and greed talked about in most accounts of the GFC.

When financial affairs have gone badly wrong we are bound to uncover evidence of greed and risk-taking in pursuit of even more reward, particularly among bankers and investment bankers. Perspective is needed in forming conclusions. I once took out a margin loan from Macquarie Bank (they sweetened the deal with a free bottle of Grange) to purchase a number of shares, which subsequently increased in value. This was astute investing with just reward. Later, I unwisely, as it turned out, bought shares in OneTel. I mistakenly thought it was backed by Packer and Murdoch (the youngers) and that rich rewards lay in wait. I lost all of my investment. This was risky betting in greedy pursuit of unearned enrichment. Astuteness and just reward, on the one hand, and reckless risk-taking and greed, on the other, can sometimes be distinguished in sharp relief only through a retrospective prism.

It is morally satisfying to be able to pin responsibility on “suspect” people doing “suspect” things. There they were, walking around with responsible highly-paid jobs in conservative suits and all the time harbouring reckless and greedy thoughts. Judgments are formed when the music has stopped; not when the music is playing and the apparent excesses are (“mostly”) par for the course. “Mostly”, because, life being how it is, there will always be instances of reckless behaviour and greed way beyond the norm. Some of these have been set out in lurid detail in accounts of the GFC. Some chief executives and their acolytes—among them, “fat cat bankers”, as Obama presidentially called them—were paid exorbitantly, even by the standards of boom times. But let us have perspective; instances of massively large bonuses, and the pursuit of them, however unsettling, offensive and disreputable, were symptomatic; they played little part in causing the GFC.

Banking is always susceptible to catastrophic economic events, and it has little to do with instances of reckless behaviour and greed. This can be illustrated by the example of the insurance company AIG, which effectively got into the territory that banking occupies, and into trouble, by selling credit default swaps. For a premium AIG issued credit default swaps to insure the holders of securities against the “risk” of default by the issuers of the securities. The “risk” of default however is a misnomer, in this case, because each batch of securities has unique characteristics. Risk comes with homogeneity and history. Actuaries can then calculate the probability of an event and set an insurance premium. With uniqueness comes “uncertainty” (the territory of banking) not calculable risk. This is taken into account by banks, when making loans, with a strategy of diversification. Interest rates are set to take account of some number of likely defaults. There is not the same science to it as with accommodating risk; and unfortunately, as Nassim Nicholas Taleb has reminded us (in Fooled by Randomness and Black Swan), diversification doesn’t work in a context of widespread catastrophic economic events.

Insurance can be shielded by regulators making sure insurance companies largely stick to their knitting of dealing in risk. The knitting of banking is dealing in uncertainty; and its susceptibility is innate and unavoidable. If the economic crisis is serious enough, banks will need bailing out, to one extent or other, as experience has proved. Reinhart and Rogoff (This Time is Different, Princeton University Press, 2009) make the point: “for the advanced economies during 1800–2008, the picture that emerges is one of serial banking crises”. This can be prevented only at the overwhelming cost of severely stunting banking. Without being fatalistic, or of understating the value of sensible provisioning or prudential oversight by diligent boards and regulators, nothing much can be done about it.

If individual instances of reckless behaviour and greed played little or no part in causing the GFC, another quite different kind of recklessness and greed may have. It is the kind that is promoted by an entitlement culture, within which everyone agrees to entitle everyone to more (regardless of capacity) and where frugality and saving give way to spending and borrowing.

Garnaut, and other economists, in recognising the paucity of saving, attribute it to wealth effects—loose monetary policy leads to rises in assets prices; people feel wealthier so they borrow and spend more. Okay in part, but the strength of that effect owed something to the decline in saving in the first place. The decline in saving has been going on for some time. In the USA, the personal saving rate has been trending down since the early 1980s, and perhaps since the mid-1970s. Loose monetary policy can’t account for this because, for most of that time, the Fed funds rate was not on an accommodating setting. (See Department of Commerce, Bureau of Economic Analysis & Suzanne Rizzo, “A Rough Guide to the Neutral Fed Funds Rate”, Economic Snapshots, June 2004.)

It is difficult to be definitive about why the saving rate in the USA, and in other industrial countries, has been trending down; complex demographic factors potentially come into play. It is, nevertheless, a reasonable hypothesis that one of factors suppressing the propensity to save has been the significant and continuing growth (and promise) of publicly funded (and unfunded) welfare entitlements. When society takes responsibility for your welfare, it would be counter-intuitive to think it would have no effect of eventually, and progressively, eroding self-reliance and saving; and, more generally, of promoting an entitlement culture. And it doesn’t stop there. Adding to, and compounding, the depressing effect of the welfare state on private saving is public overspending to support it. What a parlous position we can get into when everyone makes promises to everyone that can’t be afforded. Perhaps we are seeing in the GFC some of the effects of a creeping socialism experiment: the inexorable and uninterrupted expansion of the welfare state in Western industrialised countries—without abatement even under Reagan and Thatcher despite their advocacy of self-reliance—rather than a neo-liberalism experiment.

Two conclusions can be drawn: one certain, the second tentative. First, the steep decline in the propensity to save increased the severity of the GFC. If saving had not fallen so much, Greenspan’s loose monetary policy would not have engendered the same magnitude of borrowing and securitisation; global imbalances would not have been as great and the housing loan spiral would not have been so acute. Second, a persuasive case can be made that part of the trend decline in the propensity to save is due to the long-standing and continuing expansion of the welfare state and, its follower, a culture of entitlement. The GFC was not, of course, attributable to this, but part of its severity may have been.

The GFC might be viewed as the comeuppance of untrammelled neo-liberalism, otherwise called reckless, greedy capitalism; and the solution: liberal doses of Keynesianism and government intervention. Alternatively, while accepting the inevitable ups and downs of a capitalist economy, it might be viewed—or, more correctly, its severity might be viewed—as the outcome of the Keynesian and socialist experiment that has been under way since the Second World War, that has led to public over-spending and undermined self-reliance and frugality; and the solution: a return to classical economic principles of balancing budgets and encouraging production and saving. Take your political pick, I suppose, but unsustainable debt is always and everywhere the hallmark and harbinger of financial crises, which suggests that policies that promote spending and undermine saving are not helpful.

Finally, people of whatever view should remain grounded. It wasn’t, as we are discovering, the end of the world as we know it. Reinhart and Rogoff (referred to above) provide good perspective by looking at eight centuries of financial crises since medieval times; from which it can be concluded that the GFC, though only matched by the Great Depression in its immediate severity and spread, was part of an endless series of financial crises. At the same time, a nagging doubt remains about societies that may have lost (or had taken from them) the incentive and will to save. This is not necessarily a passing fancy or something that can be largely regulated away, like sub-prime lending.

Peter Smith is a former CEO of the Australian Payments Clearing Association.

He wrote “Taxing the Rich and Spreading the Wealth” in the March issue.