The Long Read: James Bevan on savings and deflation

One of the least understood or indeed modelling-friendly ‘variables’ within a macroeconomic system is the household savings rate.   For example, we know that culture and overall demographics within a country play important roles in determining aggregate savings behaviour.

Equally interest rates and interest rate expectations are likely to exert an important influence. The influence, however, may quite possibly be non-linear. Thus, we can suspect that the relationship between savings and interest rates may be essentially ‘U-shaped’, in that people will have a propensity to save more either at very low yields or very high yields.  Experience suggests that the bottom of the ‘U’ for the savings rate is likely to be yield somewhere around the range of 3-8%, at least in developed market economies such as the US.

The absolute level of incomes will also likely affect savings rates, as will the distribution of incomes. Thus if the income data are heavily skewed with a lot of less well-off people and a lot of high earners, many people may simply not be able to afford to save.

Asset prices and ‘wealth effects’ also play some potential role in determining the amount of current income that is devoted to savings, although the coefficient on this particular factor is likely to vary according to whether the higher asset prices can, or cannot, be used as collateral within a fully functioning (or not) credit system.

Leading on from this, the availability, or otherwise, of credit will play a large role in determining the savings rates, as will any legacy effects of previous credit excesses.

Similarly, household expectations over the outlook for inflation or deflation can also be expected to play some role.

People’s expectations over the economy’s – and more particularly their own – future income trends will influence just how much money people will wish to save in the current period.

Savings rise not fall
These factors have implications for the current global economic situation. In the US, while there’s been plenty of asset price inflation, the lingering difficulties with regard to the availability of credit have probably blunted any wealth effects.

Higher asset prices have therefore not led to the type of fall in the savings rate that many were projecting.  What’s more, household expectations for the future seem to be modest and interest rates are particularly low by historical standards. Along with the household sector’s still high debt burden, and the low level of home equity ratios, these factors probably argue for a higher rather than lower savings rate. But we can suspect that the crucial factors in the increase in the savings rate within US over recent months has been a fall in commodity and fuel costs, which have served simply to make it possible for more people to save.

Hence, the US savings rate has increased significantly of late and we may suspect that this is not merely a temporary or transitory factor.

Turning to Japan, this is a country in which the population is rapidly ageing and which is facing deep-seated problems in the funding of its pension systems, with the consequence that the savings rate has also increased of late, even as real income growth has improved.

Importantly, despite Mr Abe’s commitment to create inflation in the future, households evidently remain cautious over the outlook for their real long-term wealth. As a result, their level of cash saving has increased despite the recent increase in equity and property prices.

Meanwhile, with Germany, which also faces some very challenging demographic headwinds, it seems that the recent collapse in household expectations for real interest rates over the next five to ten years, has helped to drive the savings rate appreciably higher. Arguably this represents the risk that Europe may have ‘gone too far’ with its yield compression – and this may be one reason why the ECB seems uncertain as to its policy agenda.

The same effect may also be present in France and to a lesser extent in Italy.

With the UK, the data are more mixed. There have been some asset price gains and the credit system is functioning, while the demographic situation seems less encouraging of higher savings.

Within Latin America the recent fall in commodity prices and the resulting decline in the countries’ terms of trade indices seem to have shaken people’s perceptions of their long term permanent incomes prospects. Equally, interest rates – particularly in real terms – have increased in parts of Latin America to relatively high levels and we may suspect that these factors taken together will soon result in higher savings rates.

With Australia, we may suspect that the still high cost of living could simply be preventing people from saving even as their perceptions of their real longer-term wealth decline. But we can also suspect that if land prices  fall this might change appreciably.

As for New Zealand, its savings rate is being buffeted by the ‘Quake rebuild’ effort, the rise in house prices with some credit growth, and the country’s rapid population growth. These factors may serve to keep the savings rate relatively low over the next few years.

As for other economies which are important in terms of scale, fund flows and the mix of spending, saving and investing, China has experienced strong equity market gains, albeit that the gains have been built on an extraordinary surge in household leverage rather than improving fundamentals. There’s also ongoing house price deflation, the emergence of a credit system that only seems to want to lend to investors running on margin financing, a downturn in labour market conditions, and perhaps rather less optimism than there once was in the economy.

These factors in aggregate argue for a higher rather than lower savings rate. As a big picture issue, China’s ageing society may simply need to save more for the future. Then there’s India, where weak sentiment and slower credit growth may finally lead to a much needed increase within the savings rate.

Too much saving/too little investment
As we’ve discussed, one of the significant and fast-evolving themes of 2015, albeit a largely unexpected and perhaps still unrecognized one for many, is that there has been an increase in global savings rates.

It may well be that the trend has been accentuated by the redistribution of incomes from spenders (such as Australasia & Brazil) to savers (in China, Japan and Germany) and this shift has played out in commodity prices as well as aggregated savings rates and behaviours.

In determining the likely impacts on economies and markets, we need to understand where the savings will flow. For the global economy writ large, it would be helpful if new savings were deployed to finance the acquisition of productive capital, to support demand trends and to foment a positive and sustainable cycle of wealth creation.

What evidence there is, points to investment rates being either low or falling, likely reflecting weak confidence, over-regulation and poor corporate cash flows. These factors are themselves the product of rising household savings rates. Thus, despite the slightly better durable goods orders over the last couple of months, the trend in US capital spending looks to be flat at best. In Europe, the data suggest that the ECB’s latest policy measures have failed to encourage more investment by the private sector. Meanwhile, with China, both investment and investment intentions are declining at a relatively rapid pace, suggesting the country’s post-2008 credit driven boom in capital spending is firmly over.

In practice, there seem to be very few countries where data point to rising levels of capital expenditure, suggesting that the problem that occupied Keynes’ attention in the 1930s, of too much saving/too little investment, may well be re-appearing.

In terms of Keynes’ teaching and experience, we know that in any individual economy, it is a mathematical

identity that the level of savings minus the level of private investment must be equal to exports minus imports plus government spending minus tax receipts.

If savings less investment are however higher than the sum of the other factors, then the level of aggregate demand (i.e. total spending) will naturally tend to fall short of what is required to support the level of incomes. This will usually have deflationary consequences for the economy until something else changes in the system, such as more exports, fewer imports, more government spending, lower taxes or a fall in savings rates. However, it is, of course, true that for the world economy as a whole, exports must equal imports, implying that the difference between savings and investment globally must be equal to the global public sector budget deficit.

Austerity pursuit
At present, many governments are focused on the pursuit of fiscal austerity and the reduction of budget deficits. Ricardo’s Equivalence Theorem holds that a lower budget deficit should over the medium encourage people to save less in order to ‘compensate’ for the increased public sector saving. In reality we presently have a situation in which global savings are rising relative to investment but government spending is falling relative to taxation. It’s difficult to imagine a more inherently deflationary scenario.

As to whether the current deflationary scenario will persist over the medium term, it depends on what happens to the excess savings. If the savings that are created (particularly those in emerging markets and peripheral Euroland) are simply used to discharge existing debts and not used by recipient banks and institutions to fund new credit growth, then the deflationary shock will likely persist. Worryingly, there is considerable evidence that this is happening, particularly with regard to the current flows back into the US from its former EM debtors.

One additional challenge is that much of the increased savings from EM and parts of Europe are being achieved via debt retirement. The proceeds of repayment end up in the US banking system, which is presently constrained by the regulatory environment and therefore unable or unwilling to extend new credit.

The net result is that we have a situation similar to that experienced in the late 1920s and during the 1930s, when the US received large debt repayments and other capital inflows but was unable to recycle receipts. The result was that the process became highly deflationary for earnings and activity rates within the global economy. We can hope for banking de-regulation to head off the problem, but this may take time.

Whilst savings aren’t ending up as genuine investment, some part of the increased savings flows, including many of those from China, will flow into asset markets, supporting equity markets in the US and China, and property markets elsewhere. It is not clear whether these flows will have a positive, neutral or even negative impact on global growth.

If some of the flows simply succeed in making residential property even more prohibitively expensive for domestic residents, then we may end up with even higher levels of saving. Whilst we tend to regard richly priced housing as a British problem, prices look red hot in Sydney and parts of the Bay Area in the US, demonstrating that what we are experiencing in the UK is really part of a much larger and pervasive global picture.

Bubbles
Looking forward, these flows of savings look set to continue in the near term, and we should expect in consequence, an increased incidence of bubbles in some markets.

As part of this development, we should suspect that savers or their advisors will attempt to find ‘new sectors’ for their funds, and as a case in point, infrastructure project finance may well turn out to be the next bubble.

Looking on the bright side, fund flows into the infrastructure sector could support an increase in useful and productive activity rather than simply higher prices and lower yields. Clearly, one solution to the savings/investment balance is more investment, although we will need to watch that infrastructure spending does not simply involve ‘roads to nowhere’ as happened in Japan in the 1990s and 2000s. Ideally, we need higher investment spending, supporting growth in response to either technological change or to appropriate deregulation by the authorities. This is what we’ll also look for, but there are few signs of progress at the moment.

Against this backcloth, avoidance of a new global deflationary scare later this year or next year, will likely require a significant increase in government budget deficits to counter the current ongoing rise in savings. This would be the text book Keynesian solution, but jars horribly with the current political stance of developed market governments. We have therefore something of a problem. If we join the dots, absent a change in government policy, we could well see sector specific bubbles in asset markets in the near term, with a growing global deflationary threat that may eventually undermine corporate earnings and overwhelm equity markets.

In summary, the surplus of savings within the global economy may well serve to support asset markets for a while longer and indeed drive the emergence of new bubbles. But we can expect that financial markets will not be able to ignore deflation in the global economy indefinitely. In terms of timing, markets could be tested later this year, particularly if the situation in China continues to deteriorate and the RMB were to join the list of weak currencies. In this context, ongoing weakness of the yen is unwelcome as it increases pressure on China to follow Japan’s lead. If we’re really gloomy, it may be that the arrival of the next deflation scare ends up not just undermining markets directly but also the current widespread faith in policymakers – much as occurred in the 1930s.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

Photos:
Yiannis Theologis Michellis, Flickr
Adam Keys, Flickr