There is debate (and confusion) over whether the average American has actually increased his saving rate or whether this is a mirage. Ha!… Felix Salmon points out that some economists actually think that buying stocks and bonds is consumption – not saving. Much of the confusion arises from the need to distinguish between “investors” and “savers”. There is a legitimate need for theory to take into account the possibility that the investor and the saver are not the same person, but some then go on to describe investors as “wealthy” and savers as non-wealthy, as if this is the chief issue. If a saver puts his savings in any other financial instrument besides cash, has he become an investor as well as a saver? Do only “rich” savers buy bonds, while non-rich savers put their savings in their mattress?
In my doctoral program, I took a class called “Capital Formation”. It was all about understanding how and why real productive capital assets were created. Investing is a real phenomena. That is, we should think of investment as increasing the supply of physically productive capital in the world. When a saver buys a bond, that does not necessarily mean that the total supply of real capital has grown. In fact there’s no reason to expect that it has. It’s really another issue. The difference between the supply of financial assets in the world and the supply of real income producing capital in the world can be vast. More on real investment in another post.
For now, let’s get back to saving… Typically, freshman economics texts suggest that higher interest rates (i.e. higher returns on bonds and stocks) encourage people to buy those financial instruments and, thus, save more. This “income effect” is accepted wisdom, but does it cover all the bases? Answer: only partly. The Theory of Consumer Choice says we have to consider the effect of higher interest rates on wealth too. The wealth effect is opposite in direction from the income effect, so that as Greg Mankiw says in his Principles of Economics text, “Unfortunately, research has not led to a consensus about how interest rates affect saving”.
OK…so when the Federal Reserve reduces the interest rate it charges member banks ostensibly to “stimulate the economy”, what does that do to consumer saving? Answer: WE DON”T KNOW! A saver might have a goal that involves saving each year for 20 years to be able to retire and live on (say) $50,000 per year after that. With now near-zero interest rates available, that saver now needs to save more to achieve his goal, than previously. And this ignores the increased amount of precautionary saving needed to offset the recent rise in general uncertainty about potential job losses, etc. Has the saving rate risen lately? The government says it has, at least in aggregate. But even if it hasn’t, we can surely see why people might want to save more.
Bloomberg reports that the evil “bond market vigilantes” are trying to prevent the government from doing what it thinks it needs to do to revive the economy:
For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.
“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York. “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”
“The vigilante group is different this time around,” said Mark MacQueen, a partner and money manager at Austin, Texas- based Sage Advisory Services Ltd., which oversees $7.5 billion. “It’s major foreign creditors. This whole idea that we need to spend our way out of our problems is being questioned.”
Swamp Report congratulates bond market participants for just saying no and suggests those “vigilantes” keep up the good work even if they are the new axis of evil…
“Proponents of CDS contracts argue that losses on additional “speculative” positions on Lehman as a reference entity are not a loss per se; that is, there are no “real” losses. …
The true issue is subtler – the CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%. It increases the embedded leverage in the financial system to a specific event namely the default of the reference entity. It also may absorb available liquidity and capital creating systemic issues.
The use of CDS’s to “insure” or speculate on the credit worthiness of governments is particularly troubling:
“The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS)….
The spectre of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.
The unpalatable reality that very few, self interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency.