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Thursday, June 28, 2007

The Savings Paradox

Savings and Investment are two sides of the same coin. Though saving money is considered desirable, it has its costs. While savings are necessary to sustain investment in an an economy, consumption is necessary to make the same investments profitable. We have heard of the huge domestic savings of East Asian economies, and especially China. In January 2005, the present US federal Reserve Governor, Ben Bernanke alluded to a "savings glut" in the world economy.

East Asian economies are interesting examples of the complex interplay of savings and investment. Historically, most of these countries have been huge savers, with small consumption growth. Some Asian economies, especially Japan, even suffer from acute demand compression. Consumers are not willing to spend as much as their incomes would afford. There could be many reasons for this. First, historically in many closed economies like India and many in the East Asia (remember that most East Asian economies were heavily import protected till very recently), in the absence of choice, the consumers had limited spending options. Second, culturally many Oriental and South Asian countries encourage thrift to conspicuous consumption. Third, the higher interest rates afforded numerous lucrative investment options (though this cannot be said about Japan). Fourth, the low inflation in many East Asian economies also meant that spending was not that attractive an option, as people could afford to postpone spending. Fifth, all these economies have massive young population who tended to over-save to improve their future prospects. Finally, Japan suffered from deflation in the late nineties and early years of this millennium. People started postponing their purchases in anticipation of further falling prices. A vicious cycle got precipitated and the deflation worsened.

Savings also depends on the rational expectations of the consumers. If the Government is running higher deficits, citizens generally respond by cutting down on present consumption and starts saving in anticiaption of future tax increases.

Economic history teaches us that high domestic savings are essential in generating the investment required for high economic growth rates in any country. The huge 35-45% savings rates of the East Asian economies during the decades of sixties to nineties, played a critical role in sustaining the East Asian economic miracle. The domestic savings rate of China, recently crossed 50% of the GDP. The proactively interventionist Government bureaucracies in Japan, Singapore, Malaysia, South Korea, and Taiwan channelled these huge savings towards priority sector investments, that sustained the export led economic growth model. Besides supporting investment spending, savings also lubricates and adds liquidity to the financial system, thereby strengthening and deepening it. A robust financial sector is vital to the long term economic prospects of any economy.

What are the deficiencies of a savings driven economy? Savings yield high returns only if there is demand for investment spending. Investment spending in turns depends upon consumption demand. Till recently, the East Asian economies were able to sustain investment spending by maintaining huge exports. But now, with currencies appreciating and faced with the prospect of falling demand in US, these economies have to look internally for sustaining their economic growth. Further, excessive savings can also increase inequality in an economy. The rich generally save more than the poor and in a context of excess savings, the rich over-save, thereby deepening the inequality gap. This is increasingly evident in all the economies of East Asia. In contrast, increase in consumption can contribute directly to the economic growth, which has a direct multiplier on the incomes of all the people.

How do we generate consumption demand? One way to get people to start consuming more and saving less is to generate inflation. During times of inflation the purchasing power of our investments decreases and the costs of borrowing fall. It will encourage people to pull out their savings and start spending. (Paul Krugman famously advocated that Japanese Central Bank should signal inflation to get Japan out of the liquidity trap in the nineties) Opening up the economy will surely help broaden the market and increase choice, thereby giving a filip to consumer spending. We need to look no further than what happened to the Indian consumer durable goods market after liberalisation. Lower interest rates will also be an incentive for people to curtail investments and encourage borrowings. South Korea has been a successful example in generating a consumption boom by among other things lowering interest rates, encouraging borrowing, and the use of credit cards.

What are the consequences of low savings or dis-savings? The United States, since the late nineties, has been experiencing the biggest consumption boom in history. It has been fuelled by a massive rundown on domestic savings, with household savings recently moving into the red. The "wealth effect" generated first by the Information Technology (IT) and the telecoms bubble in the share market, and later by the rising real estate market, has empowered the American consumer to throw caution into the wind and spend as though there is no tommorrow. The historically low interest rates generously contributed towards the growth of both these bubbles. The weak dollar which made the cheap East Asian and Chinese imports even cheaper, only multiplied the wealth effect. But this massive run down on somestic savings has spectacularly distorted the American macro-economic picture. Its impact will be felt for many years to come.

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