Magazine | December 16, 2013, Issue

Raising Saving

The alternative is a much larger entitlement state

Americans don’t save enough. In 1960, the personal-saving rate — the share of people’s after-tax income that they save — was 11 percent. By 2007, it was under 3 percent. Saving rebounded following the recession, but not by much: In August 2013, the saving rate was just 4.6 percent. A 2009 survey conducted by market-research firm TNS found that nearly half of Americans don’t believe they could come up with $2,000 in 30 days if they had to.

This is a big problem, because a low-saving economy experiences less stability and growth, and a low-saving society is less resilient. When households have more debt, recessions are worse and it takes more time to recover. Debt-plagued recessions are inevitable in a low-saving economy: People who have no financial cushion must take on debt to finance any economic setback.

According to economists Atif Mian, Kamalesh Rao, and Amir Sufi, indebted households were much more affected by the recent recession than households without debt. Households in high-debt areas experienced more unemployment and larger wealth effects (changes in consumption as a result of perceived changes in wealth). And, because their homes made up a greater share of their savings, they also faced tighter credit constraints. This forced them to cut consumption, regardless of interest rates.

Saving provides the capital that fuels economic growth. In every economy there exists a certain level of saving that maximizes growth. Recently, the American economy has run below that level. Corporate saving has increased, but not enough to compensate for the decline in household saving. The government has borrowed more from abroad to make up the difference. Even if borrowing indefinitely were possible, households, which make up the foundation of the economy, would remain fragile.

Over the long term, if people don’t save enough for retirement, they’ll consume less when they stop working. As they face health problems with inadequate savings, more retirees will qualify for Medicaid, putting more upward pressure on future entitlement spending and increasing the burden on future workers.

The saving rate has been declining since the 1970s. According to the Federal Reserve’s Survey of Consumer Finances, despite low saving, the median net worth of middle-income Americans increased 5 percent between 1989 and 2007. Then it fell 18 percent by 2010. The rise and fall of house prices accounts for nearly all of these fluctuations. Housing wealth became a larger share of household portfolios between 1989 to 2007, at the expense of more liquid financial assets. The value of net financial assets fell 38 percent from 1989 to 2007, despite record-high stock and bond prices. Since the recession, households have shed their debt and saved more, but their net financial assets were still down 19 percent in 2010 compared with 1989.

Another remarkable trend is how much more debt Americans now owe. Median earners’ average leverage ratio (the ratio of debt to assets) nearly doubled between 1989 and 2010, from 14.5 percent to 26.5 percent. This trend has not been limited to young people, who have more student and housing debt. According to University of Pennsylvania economist Olivia Mitchell, Baby Boomers, who are at their peak of lifetime wealth, are approaching retirement with more debt than any previous generation. In 1992, 64 percent of people on the verge of retirement held debt. In 2008, 71 percent did, and the median amount of debt had quadrupled in real terms, to more than $28,000. Boomers have been spending more on housing, and many have credit-card debt as well.

No single factor explains the decline in saving. From the mid 1980s until the Great Recession, credit was plentiful, recessions were shallow, and periods of joblessness were short, all of which may have led people to perceive less risk and choose to save less because they thought they didn’t need much financial protection.

Another culprit may be stagnating income. Median real take-home pay has barely grown since the 1980s. Yet many Americans have still expected rising living standards and consumed more, saving less to make up the difference. There have also been few rewards to saving: Returns on safe assets (bonds, deposits, and CDs) have declined, and credit has been cheap.

Another reason for the decline in saving — other than in real estate — is government policy, though anti-saving policies pre-date the decline. The federal government taxes asset returns but not consumption. The social safety net — including unemployment insurance, Medicaid, and Social Security — gives households fewer incentives to save. In a 1996 paper, Larry Kotlikoff, Jagadeesh Gokhale, and John Sabelhaus argued that massive wealth transfers through entitlement programs accounted for most of the decline in American saving.

Some government policies in the last 30 years have encouraged saving, mainly through the creation and broader adoption of tax-deferred retirement accounts. There’s some debate about whether this has resulted in more saving overall or simply led people to save less in other ways. Yet even if personal retirement accounts — which have largely replaced firms’ saving through defined-benefit pensions — have increased household saving, they haven’t been effective enough. The median net worth of households on the cusp of retirement is just $173,000. That translates into less than $700 a month of real income.

#page#Policies that encourage retirement saving have been overwhelmed by the policy goal of increasing home ownership, which has encouraged debt. The 1986 tax reform limited the tax exemption of interest payments but preserved it for mortgages. In 1997, Congress exempted from taxes most capital gains from the sale of owner-occupied homes. People can even withdraw money from retirement accounts without penalty to buy a home.

Financial technology has also evolved. Mortgage securitization, propelled and supported by quasi-government entities, made mortgages cheaper and more available. It also made it easier to take out a home-equity loan on a house’s rising value. Even if they were leveraged, households’ net worth increased because house prices rose faster than the value of their debt. This wealth effect encouraged more consumption and more household leverage.

Since the recession, monetary policy has tried to boost consumption through low interest rates. While Fed chairman Ben Bernanke acknowledges that low rates harm savers, he is quick to argue that the benefits of the improved economy will outweigh that cost. Although low rates have helped households reduce debt (by reducing their interest payments), it is not clear how effectively the Fed’s low-rate policy has boosted consumption. If people are barely saving to begin with, they have little capacity to consume more. In addition, the non-rich saving population tends to be middle-aged households approaching retirement. Low interest rates are supposed to encourage savers to invest in riskier, higher-yielding assets, an inadvisable decision for these non-rich savers. If they stick to low-risk assets as they should, the low rates could have the wrong kind of wealth effect on them: By making them feel poorer, it could induce them to consume even less. In this respect, the low-rate policy may be self-defeating.

Meanwhile, savers who complain about meager returns are practically vilified. New Yorker columnist James Surowiecki wrote a column earlier this year titled “Shut Up, Savers!” in which he claimed that too much sympathy for the plight of savers is “dangerous.” He argued that low rates aren’t a big problem because many people are net debtors, but neglected to mention that low rates contributed to that undesirable situation.

The problem of inadequate saving is being confused with worsening income inequality. We are seeing more calls from left-wing economists like Paul Krugman to increase taxes on capital gains, the preferential treatment of which mainly benefits wealthy individuals. In 2013, capital-gains taxes rose only on higher earners, while President Obama’s 2014 budget plan includes a proposal to limit the size of tax-advantaged retirement accounts to about $3.4 million. Both of these policies discourage saving, but they are justified on the grounds that they affect high-income individuals.

Such policies ignore the normal life cycle of asset accumulation. The wealth of most people peaks as they near retirement, and this is also when their lifetime earnings are highest. Discouraging saving at this stage of life would be a mistake. Instead, we need policies that encourage all Americans to save more throughout their lives.

America must either make a greater commitment to encouraging saving or adopt a more comprehensive safety net that will replace individual saving. If people lose their jobs, they’ll rely exclusively on unemployment benefits. If they need to move or retrain, the government will finance it. When they grow old, they’ll depend wholly on the government for their consumption and health care.

A government-provided safety net ensures that the poor and most vulnerable are protected, but a far-reaching one that takes the place of middle-class saving creates great inefficiencies. Households have varying needs, and each household faces unique shocks in its lifetime. Personal saving, not a government safety net, is best suited to protect most people.

Thus, public policy should encourage saving through the tax code and reduce the code’s current disincentives to save. It should increase the limits on contributions to tax-advantaged retirement accounts and make it easier to take hardship withdrawals, but eliminate the option to use the money in these accounts to buy real estate. This would enhance the incentives to save for both retirement and life shocks. We should also lower or eliminate capital-gains and dividend taxes and introduce a progressive, federal consumption tax.

Congress should revisit housing policy, too — in particular, the tax deduction on mortgage interest. The merits of home ownership as a policy goal are debatable, but it’s hard to justify many households’ holding only a single, illiquid, highly leveraged asset.

Such policies may mean less growth in the short term as the American economy weans itself off overconsumption, but they would provide more stability and growth later on.

– Allison Schrager is a writer and economist who focuses on pension finance and saving.

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