Tuesday, December 9, 2008

The Myth Of Savings In UK

Source: http://www.statistics.gov.uk/

Savings ratio: Defined as proportion of disposable income that is saved rather than spent. For instance, if an individual has disposable income of £2000 & £500 is saved then we say the savings ratio is 25%.

But the figure here doesn’t reflect the true situation in UK & we never seen such high savings ratio. 12% is high enough & it was achieved in the earlier years.

Why savings ratio is high earlier?

(1) Economic growth. UK registered an average of 2.5% economic growth after the post-war period & this figure is much higher compared to other large EU economies such as France, Germany & Italy. The robust growth is accompanied by rising real income & living standards. People have more money for consumption & to set aside for savings

(2) High interest rates offered. When Lady Thatcher took over administration in 1979, it was a period of chaos. Inflation was as high as 27%. Being a monetarist, she believes that to control inflation she must control the money supply. As such interest rates were raised to as high as 14% & this act as a strong incentive to save rather than spend

(3) To repay debt.
It all began towards the end of 1980s which coincide with the Lawson Boom. In that period, Nigel Lawson the Chancellor, took the populist step to slash income tax. Also in the same period, interest rates were so low that it actually encouraged more people to borrow & finance a property. Prices of property shooting up to 300% are common sight that time. Growth of 5% in 1988/89 was proven to be unsustainable. Rose in inflation, was followed by high interest rates & this is a painful experience for those who had take out loans. Recession followed suit after that. People became thrift to repay all the accumulated debts in earlier years

The good things about high savings ratio?

(1) Reduce reliance of consumption-led growth.
UK economic growth is said to be fully driven by consumption. It stands at about 66% of GDP. This means if there is an overturn in consumer confidence, the public may start to reduce spending significantly & UK economy will therefore head towards a sharp downturn. Therefore UK needs some serious initiative to balance all the 4 components of AD (C, I, G & X-M) particularly investment spending & its export market. Having said that, this is no easy task. To reduce C, necessarily there must be low consumer confidence or high interest rates, but this will also pull downward the I. In other word C, I & X-M are somehow inter-related

(2) Financial backup. With high level of savings, one can prepare themselves for situations such as buying property, starting a family, retirement plan, sickness & other form of unforeseen circumstances. But it is worthwhile to take note that if the society is generally frugal it doesn’t serve well for the economy either. Japan has the largest saving in the world & the amount is remarkably larger than US GDP itself. Unfortunately its economy has remained stagnant throughout the 1990s

(3) More funds for investment. In theory as we learn in Unit 1 PPF, when the society choose to have high level of savings now, it means that there will be more monies available in the future for investment spending, thus leading to economic growth. Another way to look at this is people choose to sacrifice the present consumption in order to have higher standards of living in the future

(4) Banks can reduce lending from money markets. If all the years savings ratio in UK is high, banks, building societies & financial institutions could have avoid all the financial & economic mess that we have today. Low level of savings translates to lesser funds available for lending. Therefore in order to do business as usual, these banks will raise financing from the money market. If one of the large & influential institution such as Freddie Mac & Fannie Mae were to run into trouble, the whole financial system itself will collapse, when these banks suddenly loss the source of funding

Why savings ratio dropped in the recent years?

(1) Ease of credit.
Before the sub-prime mortgage crisis, banks are superbly generous. Many people who were not qualify for loan under a traditional state may now even get a funding. Even some people with unstable job & income could easily get access to millions. Banks were willing to lend as they assume that the property market boom will ‘go on forever’. Therefore even poor paymaster will be able to repay their loan since the value of their property is rising. Various types of mortgages were issued such as 100%-mortgages, interest-only mortgages to induce people to borrow

(2) Low interest rates. On top of banks’ generosity, basic rate that time was very low, standing at about 3% in early 2000s before gradually increased to 5.75% in April 2007. This exacerbated the lending activities.

(3) Low real return from savings. Interest rates were very high in the early 1990s, at the rate of 12%. This partly explains why savings ratio persistently staying above 10% between year 1992 to 1997. In 2000s however, interest rates were very low & even staying close to inflation. From economic point of view, this reduces the incentive to save & therefore people would rather spend rather than earning a meagre return

Interestingly from the latest data, UK’s key interest rate is 2% while the inflation is standing at 4.5% & this actually gives negative real return of 2.5%. So one could begin to argue as to why people not starting to spend then? My answer is the problems of collapse in consumer confidence & job insecurity actually dominates the argument. After all in recession, having cash in hand is the safest thing one can do

Why this is bad?

(1) Risk of default. Low savings could only imply one thing & that is people have spent too much money into the economy & this aggravates demand-pull inflation. This is likely true from UK’s experience as 66% of its GDP is dictated by private consumption alone. When inflationary pressure build up, it is very normal for the MPC to increase interest rates to slowdown the heating economy. Also it’s part of meeting the inflationary target rate of CPI 2% +/- 1%. Interest rates rose to 5.75% last year & this mean more & more people will have repayment problem. This is also one of the key arguments as to how subprime mortgage crisis began

(2) Little financial backup. People with not much savings have very little margin for error. They could face difficulty in the current period of recession where retrenchment is common or even during the period of escalating inflation

(3) Large current account deficit. UK people generally have high marginal propensity to import. With any minor increase in disposable income, large bulk of it will be spent onto consumption of imported goods rather than saved. This explains why UK’s current account has remained almost permanently in deficit. Although there is an increase in trade in services over the years, but it is still insufficient to offset the large deficit in trade in goods. Large current account deficit greatly increase the chance of currency devaluation if the country is unable to attract sufficient inflow of capital or hot money which will create the demand for its currency. The collapse of Iceland kroner is due to this

(4) Financial & economic mess. If UK’s banks have large enough pool of savings, maybe everyone could have escaped this financial mess. The problem starts when the bank has insufficient deposits to create lending, as such raising it from the money markets. Northern Rock which had went into administration earlier this year was a good example, of how dangerous it could be by borrowing from other banks. Its collapse caused a temporary panic among Britons where people start queuing up to withdraw their money even from the bank that has sound balance sheet on fear that their money could vanished into the thin air. Luckily the British government acts fast enough to given assurance to depositors’ savings

But the damage onto British economy had been done. Credit crunch means difficult for bank to give lending, thus causing a fall in demand for housing. Prices of property suffer a freefall & there is negative wealth effect. Repossessions are everywhere. The last thing a borrower would like to see is his house being repossessed!

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