Temporal Conundrum

By Daniel O'Connor of Integral Ventures, LLC

We finally did it.  This past year, for the first time since the pit of the Great Depression, we in the United States managed to drive our annual personal saving rate below zero.       

What this basically means, on the surface, is that all of us together, as a group, spent every dollar of household income we had leftover after taxes, plus another half a cent that we must have borrowed.  Of course, some of us did manage to save something last year.  But all of this saving was more than offset by all the dissaving the rest of us did.  Of course, this wasn't a great surprise.  The trend has been clear for a good many years and I've even discussed it in some previous posts, like Saving Ourselves and Saving Themselves?

What does it mean for us?

To answer this question, let's review some just-in-time theory.  The personal saving rate is a derivative of the fundamental trade-off for every household--consumption versus saving--and it reflects householders' preferences for allocating their scarce resources over time.  Given a flow of after-tax income, householders can either use the money for current consumption or save it for future consumption.  This temporal trade-off is known as time preference because it expresses a preferential relationship between a particular good now versus that same good in the future.  It is considered by economists of the Austrian school to be the subjective origin of the interest rate, because the greater our valuation of a good in the present relative to our valuation of the same good in the future--i.e., the higher our time preference--the greater the implied interest rate in our value function and the greater the interest rate must be to induce us to defer enjoyment of this good through saving.  Time preference may also have a neurological origin, as I proposed in The Neuroeconomics of Time.

So how can these ideas help us interpret the negative personal saving rate?

When we see householders as a group choosing to save none of their current income, preferring instead to use it all for current consumption, we can infer that they do not value the future enough to save for it.  Perhaps they imagine that they do not need to save for the future because they already have enough savings in the form of assets (like home equity) or because someone else is doing it for them (like a government or corporate pension).  Either way, it's pretty much the same implication.  When people lower their valuation of the future or the goods they might buy in the future, they are expressing what is known as higher time preference, which is consistent with the higher interest rate that is required to induce them to save enough to satisfy investors' demand for funds.  To see what I mean, just think of how we compute the present value of a future cash flow by applying a discount rate: the higher the discount rate we apply, the lower the present value of the future cash flow.  Thus, the lower our present valuation of our collective economic future, the higher is the implied interest rate that should prevail in the markets for money, credit, savings, and investment.  This is how markets work, like a dynamic system seeking a reasonable balance.

But if there is one thing to which we've all grown accustomed in the past several years, it is lower interest rates.  According to the theory of time preference, lower interest rates imply lower time preference and therefore a relatively higher valuation of the future in relation to the present.  A lower discount rate applied to the future cash flow in our example will generate a higher present value of that future cash flow.  So the relatively low interest rates in recent years would seem to be an indication that we householders value our collective economic future very highly--as if we are saving a great deal more than we really are.

Thus, we have a sort of temporal conundrum. 

On one hand, the trend in personal saving suggests that we place so little value on our economic future that we'd rather just consume everything we possibly can in the present, without regard for future consequences.  On the other hand, the trend in interest rates suggests that we value the future rather highly and therefore save a significant portion of our income so that businesses can invest in the creation of the economic product that we expect to enjoy in the future. 

How can we resolve this temporal conundrum?

By recognizing that the monetary policies of our own central bank and the central banks of our trading partners have been distorting market interest rates to such an extent that we householders are literally behaving as if we can consume all our income today, while simultaneously saving enough for the future we value--consuming our cake and saving it too. 

In recent years, the Federal Reserve's inflationary monetary policy of lower short-term interest rates has been met by similarly inflationary policies of some other central banks who, in order to support their respective export sectors, have attempted to stem the dollar's natural depreciation in relation to their own currencies by aggressively purchasing US Treasury securities.  By increasing the demand for US Treasury bonds, notes, and bills, these foreign central banks have bid US interest rates down to levels that would not have existed in the absence of the policy interventions.

This multi-lateral strategy of competitive currency devaluation has produced lower-than-market interest rates all along the yield curve, from short-term rates to long-term rates, which, in turn, have created valuable incentives for households to save less and consume more.  These lower-than-market interest rates have resulted in higher-than-market rates of borrowing and higher-than-market rates of appreciation in the prices of many assets--e.g., stocks, bonds, houses--which are often touted as the increasing savings balances that more than offset any downside associated with the decreasing saving rates.  To the extent that the value functions among householders have remained relatively stable, we can be sure that we have all saved less and consumed more than we would have if the central banks had maintained policy neutrality.

So what?

The wider consequences of these policy-driven distortions in the temporal dimension of our market economy extend well beyond the seemingly mundane world of household finances, contributing to such challenges as the ominous debt trap, the recurring business cycle (which is rooted in the debt-filled gap between decreasing saving and increasing investment), and the depletion of natural capital (because excessive consumption in the present over-uses today's relatively inefficient, resource-intensive technological capital base).

The deeper implications are more difficult to articulate.  It is as if we are all contributing to a self-fulfilling prophesy that is, ironically, contrary to the conscious visions of a better future that most of us are actually trying to create in our own ways.  It is difficult for me to see a way out of these self-fulfilling, self-justifying, self-contradicting, and self-destructive dynamics without a significant transformation in the way we choose to participate in our market economy.

© 2006 by Daniel J. O'Connor.  All Rights Reserved.

See Also:

• Stable Instability
• Saving Ourselves
• Saving Themselves?
• Unprecedented Fundamentals
• Asset Price Bubbles: Monetary Inflation and Leveraged Speculation
• Mutually Assured Disruption
• Debt Trap

Comments

[Dave Iverson]

For an even more graphic depiction of the "savings problem," here's what I threw up on one of my blogs today, from Paul Kasriel, comparing 40+ years the difference between disposable personal income and expenditures on consumer goods and service plus residential investment.
http://forestpolicy.typepad.com/economics/2006/02/its_different_t.html

It makes you shudder to think what we've done. Somehow I hope you and I are at least partially wrong on this stuff. But I doubt that we are.

[Daniel O'Connor]

Thanks Dave. I really like your blog and hope that my 17 readers will visit you too ;-)

Perhaps like you, I tend to think of the future in terms of alternative scenarios with the expectation that the future as it unfolds will probably have some mix of the different scenarios, plus a whole lot that we could never foresee.

That said, it is difficult for me to develop any plausible scenario for the coming decades that does not include some sort of reckoning with this debt trap or dollar crisis-potential or stable instability or call it what you want.

It's not going to be all bad news in any case, but it's going to take some real work to get on a more sustainable path.

Take care

Daniel

[Dan]

This is a wonderful blog, Daniel, and opens up new vistas for me. Thank you and best to you.

[Daniel O'Connor]

Thanks Dan... high praise considering your wonderful blog... just added to the blogroll.