He who does not economize will have to agonize. ~Confucius
Last month, I traveled extensively through East Asia. Business seemed to be booming. Yet everyone was concerned about the financial crisis in America. The irony is that no one seemed very concerned about the financial crisis in their own countries—the crisis, they say, is America’s problem. Yet the Shanghai stock exchange index is down 57% year to date. The U.S. Dow Jones Industrial Index is down “only” 25%. If America’s equity market had declined 57%, we would be devastated. Yet in China, people are motoring on along without the kind of widespread apprehension with which America is well-acquainted. What explains the sangfroid of the Chinese? I asked bankers, corporate executives, journalists, academicians, and MBA applicants—virtually anybody I could find. The dominant explanation was that the Chinese save more than Americans and invest less of their savings in the stock market. On this hangs an insight that is virtually unreported in the media: patterns of thrift will influence the course of this crisis.
Cash reserves give peace of mind with which to absorb adversity in the markets. And on the face of things, America seems flush with cash—Americans hold $11.7 trillion in checking accounts, savings accounts, money market funds, Treasury securities, and bonds. ((Matthew Craft and Jack Gage “Cash is King”Forbes September 28, 2008.)) That’s enough to pay off all the mortgage debt in America. Also, some companies are very liquid: Dell, Expedia, Amdocs, Foster Wheeler, MEMC Electronic Materials, NCR, Cisco have cash at least as large as 20% of market capitalization. ((Jon Bruner, “Cash Rich Companies, Forbes, September 28, 2008.)) The problem is that this cash is not distributed evenly across the population. The saving rate of Americans is about 3%–the richest quintile of Americans save about 14% of their income; the least rich quintile, about 1%. ((Ron Wilcox notes that the figures for America are for savings only; if you add in the amount annually set aside for pension contributions, the figures increase to 24% for the riches quintile and 9% for the least rich. For the purposes of meeting economic adversity, I don’t think that pension “savings” should be included, since drawing on such resources merely shifts adversity from the present toward retirement.)) This compares to 50% in China, 25% in India, and 15% in France.
My colleague, Ron Wilcox, has written a wonderful book, Whatever Happened to Thrift?that is important, incisive, intuitively appealing, and accessible to the non-technical reader. The book offers an explanation of why America compares so badly to other nations; he writes that it is a complicated story:
“…what you have is a large number of Americans who believe they are not keeping up with their peers…The psychology of memory, the sociology of reference-group communication, and the economics of a widening income distribution combine to form a powerful witches’ brew of self-defeating consumption behavior.” ((Wilcox, Whatever Happened to Thrift?, pages 31-32.))
The panic Americans feel is triggered by the sudden evaporation in asset values (of housing, real estate, bonds, what have you) and amplified by the realization that for many of us that’s all we have. Thrift is important because it is the basis for creating the shock absorbers by which individuals and corporations sustain the economic blows that occur now and then. Liquid reserves offer flexibility in the face of adversity—in effect, they offer a call option on alternative strategies for the future. If you don’t have that flexibility, you are stuck with whatever the future offers. Flexibility based on liquid reserves is a very good thing, a lesson that America seemed to have forgotten by early 2007.
The bonfire of anger about the financial crisis was stoked by the dramatic developments last month—we’ve seen fingers pointed in every imaginable direction: bankers, mortgage companies, corporate executives, government officials, and so on. I think all these pyrotechnics are misdirected. The elephant in the crisis is the crummy saving rate of Americans. In other words, we all “own” this crisis—in the sense that we had a hand in creating it and must realign ourselves in forging a lasting recovery.
It is interesting to speculate how the events of the last 14 months would have been different if America saved at the rate of its leading peers. First, it seems likely that there would have been a much lower volume of Alt-A loans, liar loans, and subprime mortgage loans. Americans would have been more likely to invest the home equity necessary to merit a conventional prime mortgage. With much less of such aggressive loans, the crisis would not have occurred or spread in the same way. Second, a mentality of thrift might have suppressed the mania for speculative investing in real estate. As a saver you think long term; you envision a goal; you discount the future somewhat less than a speculator. The Chinese, for instance, are famous for saying they are more patient than Americans. Third, a culture of thrift would likely have stimulated more prudential borrowing and lending among enterprises. Hedge funds, private equity deals, and investment banks were using historically high leverage well into the current crisis: no wonder some of them are collapsing as the asset values deflate. Fourth, an America that saved more and lived within its means would enjoy a stronger currency, rely less on foreign investors, and be less vulnerable to volatility in the commodity markets, such as oil. And finally, with more money in the bank, Americans would be less prone to panic. In short, more thrift would help to prevent or mitigate financial crises.
The issue of America’s low saving rate is relevant today as we think about fighting the crisis and addressing its underlying causes. The ad hoc rescues of financial institutions and the more comprehensive Troubled Asset Relief Program that Congress passed on October 3rd are meant to address problems of solvency and liquidity in the financial system. But they do nothing about America’s low saving rate. Here are some possible actions:
**Repeal the income, capital gains, and property taxes and replace them with a consumption tax. Income taxes disfavor investment and discourage growth. Substituting them for a consumption tax would create an incentive to save.
**Educate the consumer. The average American poorly understands the consequences of failing to save and of borrowing. We need to improve the financial literacy of the individual. Will this make a big difference in national thrift? Hard to say. Perhaps the aggressive use of debt by individuals is more a matter of cultural norms than education. After all, even though China enjoys an extraordinarily high rate of saving, it seems unlikely that the average person in China is literate about the time value of money. But my own observations as an educator show that learning a few basic concepts about consumer finance makes a big impression.
**Stimulate thrift by means of special retirement systems for small-business employees, government-managed stock mutual funds, and matching savings plans for low-income people. Ron Wilcox explores these alternatives at length and concludes, “Government action can increase the personal savings rate.”
**Promote saving in all its forms, including investment in education and R&D. When a student uses savings to pay for tuition at school, he or she is merely translating savings from one form (cash) into another (know-how). The same could be said for a company that undertakes a program of research and development or invests in a new plant. Yet various frictions make lateral forms of saving difficult—taxes and transaction costs, for example impede the allocation of savings in optimal ways. Spending on education should be tax-deductible for the consumer.
**If you are an individual investor, set a stretch saving target and try to stick to it. I’ll offer a target of 15% of your after-tax income. If you are a single wage-earning mother of four, you might find 15% an impossibly high goal. On the other hand, if you are a successful investment banker, 15% may be too low. In short, set a goal that is consistent with a thrifty standard of living for you and stick to the goal. Then deploy your savings prudently. The standard goal is to have a “rainy day fund” of ready cash equal to six months of living expenses. The rest of your funds should be invested to earn a reasonable rate of return consistent with the amount of risk you are willing to accept and your requirements for liquidity.
A culture of thrift is consistent with other important values emerging in this decade. Thrift is the opposite of consumption. Think of the many ways in which we consume—not only of cash and credit, but of goods and services that produce waste and degrade the environment. Thrift is the key sentiment behind environmental sustainability. A culture of thrift would enhance our ability to leave a better physical environment for our children.
We all “own” this crisis and the challenge of recovery. When Americans embrace their role in this story, they will lay the foundation for the rebound and for sensible growth. As Confucius would say, greater thrift is part of the antidote to the agony coursing through financial markets today.