Fiscal Cliff 2013: Why Household Savings Matter the Most for US Economy

Get a grip:

"[Household savings] rates in the U.S. reached a high of 5.4% in 2008 as American households were experiencing some of the worst moments of the crisis and trying to pay down their debt, but started declining again in 2011 and are projected to fall back to around 4% by 2013."

"Some economists believe that the recession has structurally changed the pattern of consumption/savings that could last for years; others believe that an upturn in employment, a re-relaxation of credit availability and a bottoming of the housing market could re-start the spending trend."

Which brings us to deficits. What is a deficit, or what is the deficit that we often speak of? Let's keep it simple. It's the difference between our current account balance and capital account balance. That difference is called our balance of payments. Don't be intimidated by these terms: they're only words.

Let's take it slow. How do we find the current account balance? Simple. We first subtract the total value of imports from the total value of exports. The difference is called the trade balance. Look at it this way: a game of tug-of-war. Exports are the amount of rope we "pull in," and imports are the amount of rope we allow the "other team" to pull in. So, if we have more exports than imports, then we have pulled more rope into our side than we have lost. Keep this tug-of-war metaphor in mind, because it will serve a purpose throughout this post. 

Okay, so we have subtracted imports from exports. What next? Services. When a foreigner uses a service produced locally, then that local actor gets a credit. It's as if a tug-of-war participant who's currently on the bench for one team offers advice to the losing team and they use it to their advantage.

What's important to consider for services is this: services don't deliver a physical good, period. So we take the value of all of those services and add them to the difference between exports and imports. Finally, we add the value of net transfers from abroad. Net transfers are simply payments made from a foreign actor (a country or multi-national corporation based in a country) to another country.

Back to our metaphor. A math club geek has been beaten up by one team and opts to give a case of Red Bulls to the other team to boost their energy thus providing them the means to pull more rope in. The actor making the payment does so and asks nothing in return. Add this to the previous sum of your trade balance and services. The result is the current account balance. Exports minus Imports, plus the value of services, plus the value of one-way monetary transfers. 

After this calculation, you should find yourself with a negative or positive number. Bring it back to the tug-of-war metaphor. If the number is positive that means the team with the positive number pulled in more rope than the other team. The extra rope it pulled in can be used for a lot of different reasons, but let's focus on one.

Let's say this tug-of-war game is being played over a pit of lava. The team with a negative amount of rope is about to fall into the lava pit and begs for a little more rope. The team with a positive amount of rope agrees to lend the losing team some rope, but only if the losing team gives back the rope later with a little extra. Or the winning team agrees to let the losing team use one of its best tuggers to even the odds for a while. That agreement is our capital account balance.

This brings us to a fundamental idea: every country's balance of payments value is zero. If the current account balance is positive then you can invest that extra money. More importantly, if your current account balance is negative then you must find someone to lend you that negative balance. When this lending occurs, it normally involves one country that has a positive Current Account Balance purchasing the government bonds of another country that has a negative Current Account Balance. Those bonds guarantee a reward for the lender in exchange for the risk that the borrower won't pay back the loan.

It sounds crazy, but many countries have defaulted on their loan obligations. The United States of America came close last year, and technically is fast approaching a default again this year as our National Debt reaches $16.11 trillion. The deficit that you hear of is just the negative Current Account Balance. In business, a deficit is normally considered bad, but is this an appropriate conclusion. After all, what would you call a year that saw slow growth for a small business who had received a loan from a rich family member? A slow year or a year for building a foundation. The loan may have helped that small business establish networks or buy machinery like textile mills, or a fishing boat, etc.

What's important is the value those loans buy. They're laying the groundwork or infrastructure to facilitate future business. Back to our tug-of-war example, it's as if the winning team had built grooves to fit their special shoes into which made pulling the rope easier for the future. When the game started the team that built the grooves had a deficit, but they came out on top because it was a smart investment. Deficits by nature aren't bad unless the investments don't deliver profits in the future. What has driven the persistent deficits of the U.S? Consumer credit. In particular mortgages that defied logic. 

Where does household savings fit into this discussion? That question needs to be changed a little. What happens when household savings is too low? Household savings is the difference between disposable income and consumption. In other words, how much money do you have left after you've received your check and bought everything you want?

My opinion is that this economic indicator is one of the most important indications of a healthy economy, if not the most important indicator. It's a cushion that allows a family respond to shocks in the economy like high oil prices following a war in the Middle East. Moreover, household savings allow banks to loan money through the Federal Reserve system of fractional reserve banking. In other words, if a bank has $100 is total deposits, they are only required to keep $10-$15 of those deposits in the bank and can lend the rest to borrowers. The interest on those loans is ... wait for it ... NEW MONEY! The interest paid on those loans is money created out of nowhere. 

But back to household savings. What's so important about household savings? It's a cushion. Your savings is a buffer against which economic shocks rub up against. It's like the shield of a spacecraft entering the atmosphere: If the shield isn't thick enough then eventually the friction between the ship and the atmosphere (in other words, the effect of economic shocks depleting your reserves) will burn the ship to a crisp. One of the most important shocks we need to pay attention to is oil prices. We're idiots and don't understand that fossil fuels are bad for Earth but let's just look at oil prices from an economic vantage point. Here are the figures for the month-to-month changes in the price per a barrel of oil for the past year. 

 (URL: www.oilnergy.com)

No inflationary trends. The price per barrel has dropped almost $15 from January. Granted, if Israel or the U.S. attacks Iran then this chart will mean nothing. For now, this chart tells an important story. Growth has been fragile for the past year but has nonetheless been positive during that time period. The unadjusted Consumer Price Index (CPI) or rate of inflation that the Federal Reserve considers, stands at 2.2% for the past 12 months. That's below it's public threshold of acceptance.

We still find ourselves in a type of purgatory: inflation is low, unemployment is still high, and long-term interest rates are almost at 0%. Something has to move, one of those indicators has to move. As terrible as it sounds, inflation has to move. Nominal Gross Domestic Product, or NGDP, is the answer. NGDP is the output of  a country before stripping out inflation. But inflation is almost zero and long-term interest rates aren't spurring lending because no one is sure if they want loans or if they want to lend. The most obvious culprit is politics. It's as if the business community and politicians are engaging in a game theory type competition where the politicians have the advantage of waiting for businesses to make their move. The business community is holding out for as long as they can and will soon catch a glimpse of a more clear system of taxation and spending. 

The only way to lift household spending is to fix two problems. One is social, the other is institutional. First, the United States needs to restructure its economy to look more like Germany's. Period. More specialized businesses with skilled workers that offer specialized services. There are too many Wal-Marts and Costco's that are face diminishing returns and, more importantly, foster poor spending habits. Secondly, the Federal Reserve is currently convinced that monetary easing is necessary to support the labor market. I agree with this policy in the short term. However, it's no secret that the consumption portion of the current account balance calculation needs to come down. In other words, we import way too much stuff, bought on credit, than we should.

Americans need to find another niche that makes them more competitive. We need to export more. The fact that the dollar is low today and still we are experiencing record high current account deficits is a very worrying trend.