Basic Economics: Savings Accounts

Looking at the modern relationships between interest rates, taxes, and price inflation, I have wondered why anyone would put money into savings accounts or buy bonds, especially U.S. government bonds. A savings account, earning 1.6% (The top rate offered by my credit union recently.), after taxes of say 20% and price inflation of 2% gives you a guaranteed annual loss of 0.72%! The situation for bonds isn’t that much better, if at all. For someone with a higher income, with higher tax rates, the loss is substantially greater .

On the other hand, I know that savings accounts have historically been the primary savings vehicle in the U.S. I know from 100 Voices that Ayn Rand held her money from the sales of her novels in savings accounts. What is the difference between then, even as late as the 1970s and the 1990s, which is when I first realized the problem.

In thinking about this issue, one of the first things I saw is that interest rates have been declining as a trend since the spike in 1990. At that time I had a mortgage at 10.75%. The decline in interest rates since then has been the consequence of the Fed’s view that below market interest rates on loans encourages consumption and business activity and that if they don’t have the economic activity that they want, they decide they should lower rates more. Each round of recession and boom and financial crisis over the last twenty plus years has seen the Fed pushing short-term interest rates lower and lower. Today, the short-term rates are about as low as then can go. The rate the Fed controls directly, the rate it charges banks to borrow overnight funds for their Fed “reserves” (deposits) is zero to 0.25%. (Some recent auctions of German government short-term bonds have seen negative interest rates.) And, for the third time since 2009, they are trying to lower medium and long-term rates with “quantitative easing.”

So, first, the problem I am seeing is a very recent event. What are some of the consequences?

First there is the complete disassociation of savings and capital. The creation and use of capital is a vitally important activity in an economy. The creation and use of capital causes prosperity, not to mention the survival of our population. A population as large as ours cannot survive (or occur) without industrialization. Just to maintain industrialization requires capital. Economies either grow or contract. There is no equilibrium.

Over the last twenty years the number of households that have ownership in corporations, i.e., own stocks, has gone up significantly. One major reason is that people recognize that they have to have a more rapid growth in their retirement savings than can be provided by bank savings accounts. The need is two fold. With taxes and other restraints on creating wealth, they are not able to save enough. And then, price inflation has a double impact in that not only will it make the process of saving enough difficult, but it will also make the amount the retiree needs to live increase significantly and unpredictably. Even a 2% price inflation rate is a danger. That means that in just twenty years, a retiree would need 25% more cash for the same standard of living. Since many retirees live longer than that in retirement, and the percentage of people with such long lives is growing, the impact of even small amounts of price inflation is significant and ignored by the government planners. Bernanke has recently remarked that the effect of the Fed’s goal of 2% price inflation on retirees is unimportant in policy decisions.

You might think that a higher percentage of stockownerships is good for the economy. I’m not so sure. I was, but my view is changing. There is a difference between creating capital and owning existing capital. Saving and putting your money directly into a new or growing business is creating capital. Buying a stock from another owner is not.

Consider what should happen when you put your money into a bank savings account. (I am going to ignore the consumer loans and the loans to business for normal business activities.) Businesses come to banks for the purpose of borrowing money to start a new business or grow their existing company. This is the direct application of capital, i.e., new productive activity. Here we also see the division of labor at work. The person who saved the capital is engaged in his own profession or job and by saving, he is putting money into the hands of the banker whose profession is apprising risk and opportunity in expanding production. Then there are the businessmen who compete for funds by presenting their plans and expectations of profit.

The normal person does not have the expertise to appraise business opportunities. (Although in a rational culture he would have a better understand of the reality of business activity than people do today.) This is true in the case where people already know something about the industry. Some financial writers have advised investors to place their money in industries in which they are familiar. It isn’t a bad idea, but it does not address the additional need to be able to appraise the financial, managerial, and competitive strength of a company. Correctly understanding the context for investing is difficult enough for the professional, especially in today’s complex economy. For those who do not have the relevant education, experience or time, the prospects are very poor. No wonder everyone is so hopped up on the gambling metaphor for investing.

The need for non-professional investors to put their savings into asset markets is part of the make-up of the two recent booms: tech stocks and residential real estate. Without the amateur investor, both booms would have been less dramatic. Note that many of these investors lost lots of money, right along side the so-called professionals. This is over and above the normal losses that the non-professional investor tends to lose in the normal course of events. Some professionals use the activity of the individual investor as a contra indicator. If individual investors are buying, the reasoning goes, it is time to sell. Every study that I have seen clearly concludes that the non-professional consistently looses money investing in asset markets.

Then, over the last twelve years, as I have indicated in a previous post, the equity markets have failed to bring positive returns. Comparing equal dollars of purchasing power, today’s Dow (without including dividends or taxes) is 20% to 25% below the level at the end of the tech stock boom.

In fact, the only asset class that has shown consistent positive returns in the last decade is long-term bonds. But that brings us back to the beginning point, the Fed’s push to lower interest rates, because the reason long-term bonds have shown a gain is that interest rates keep falling. When interest rates begin to go up, watch out. Look at the returns of the bondholders of Greece, Spain, and Italy. When the interest rates on these dead bonds moved from less than 3% to near 6% or more, bond holders lost about 50% of their capital on the secondary market. To me, even 6% or 7% doesn’t seem very high when I wonder if the bonds will be repaid, or repaid with money worth anything.

There are surely lots of other consequences of the Fed’s disastrous decisions. Many are clearly visible, including the continued recession we are suffering through. (Officially the recession ended, but the psychology is still that of a recession, the unemployment level is that of a recession, and the government is doing all it can to keep us there, just like it did in the 1930s.) But the consequences that I have discussed are the ones I have recently added to my list.

But then there is the important question: Is the use of savings accounts by people who aren’t financial professionals a good thing in a laissez-faire economy and how?

The first thing to realize is that in a laissez-faire economy prices and wages tend to fall over time, which is the consequence of having a money immune from government manipulation. Prices fall faster than wages so that there is a continuous raise in the standard of living. That means that the dollar you place in a savings account will have a greater purchasing power over time even without consideration of interest paid.

The second important issue is the level of what is called the ordinary interest rate. That is the amount of return required for a person to delay consumption. This interest rate does not include consideration of risk, etc. I have seen suggestions that the rate of ordinary interest tends to be around 1%. That is, the normal person would be willing to put off spending $100 if in one year they had $101, assuming a laissez-faire economy. Other issues, such as the supply of physical capital (one market where supply does play a role in price) and risk factors, increase the interest rate within different market contexts.

So, if a savings account offered 2% interest, it was a great deal. The same is true for bonds issued by businesses. Saving for retirement would require much less of a struggle, later medical bills would be less of a problem, and our standard of living would continue to raise and we could have the flying car (see, my avatar means something – what we have lost due to government interference!).

Then, money placed into savings accounts was then loaned by banks to businesses who were credit worthy and had the best available plans for additional profits. Savings, that is capital, was accumulated and placed in the service of wealth creation, capitalism. That is basic banking.

I think much of the concern and fuss over fractional banking is based upon the view that banks are warehouses rather than institutions involved in the accumulation of capital. In the modern world, even ignoring the stupid, forced level of interest rates required by welfare state banking theory, savings have been diverted from banks and their major source of funds are demand deposits.

While unused demand deposits, and the goods represented by that money, are a kind of unintentional savings, real savings involves conscious decision and results in the funds being placed accordingly. When real savings is placed into profitable enterprise, and market rates of interest paid, investing and profit making activity would actually be a less risky activity.

With the manipulation of the money supply, the extensive regulation of the financial community, and the control of interest rates, none of the prices for savings or the factors of production reflect any part of the reality of business activity, market opportunities, or costs (not to mention political pull). Who knows what can or will happen when no facts are available for reason to evaluate.

So my conclusion is that in a laissez-faire economy, placing your money in savings accounts and buying bonds (of businesses) is a sane and personally beneficial decision.

In our economy, the government has pretty much taken way sane and beneficial opportunities. If you accept the idea that one should know what one is doing, then probably 90% of the investing public is acting irrationally. They do not understand the world as it currently functions, including the existing markets and the impact of government regulations and manipulations. Yes, I think that is true of many of my readers. Sorry.

Personal Responsibility

Recently, Don Watkins, in a blog posting (I can’t find the specific post for some reason, but it was on http://capitalism.aynrand.org/, which is very good), referenced an article arguing that anyone who tries can succeed, at least to some level. This article was written recently and not one hundred years ago. Now, I don’t disagree with its basic sentiment. I especially agree that one should take responsibility for one’s welfare and future. Further, I emphatically agree that we live in a world where it is possible to make our own way, metaphysically speaking. But, as I read the article, I kept wanting to ask the author if he’d been paying any attention to what has been happening in our economy and culture now, and for the last one hundred years.

I know why Dr. Watkins referred to the article. It is rare to find anyone who is willing to say anything good about personal responsibility today. Any such sentiment needs to be encouraged. But, in fact the article is wrong in its application to today’s America. Personal responsibility is not encouraged. Personal success is often disparaged (not by business people, but certainly within the culture). Most important, the government has been actively attacking personal success and making it more difficult for a long time.

I think that it is difficult to succeed today and becoming more so. I think that the article should have had some important provisos. I mean, haven’t we been saying that it matters what the government does? Haven’t we been arguing that man needs to have certain conditions to succeed and that the U.S. government has been moving away from those conditions.

Now, in order to make sense of the issue of personal responsibility in our context certain basic notions have to be made plain. Most important, and thus first, is that if man’s life is the standard of value, the actions by individuals based upon their own understandings and judgment is the only way in which human survival is achieved and prosperity or progress, in any rational sense, occurs. It isn’t the action, or the amount of effort, or the “work” done that is the cause of success, but the use of reason and the resulting ideas, and their correspondence with the real world. Nor does good reasoning guarantee success. A rational man can fail, even in a rational or free environment.

But, we are not living within a rational environment. We are living within an advanced welfare state with millions of regulations, probably a million regulators, and an endless number of imposed government costs of doing business. In business after business, the risk of failing to meet some idiotic government regulation or expense has become greater and greater. Starting a business was always risky. Small businesses have always failed at very high rates.

And then there is the issue of what our personal responsibility is.

Some guy on facebook told me that people on Social Security were deadbeats, and we shouldn’t care what happens to them. But after nearly one hundred years of regulation of the financial sector, the chances that most Americans can save sufficiently for retiring, at nearly any age (not to mention the costs of health care after fifty plus years of government interference in the medical industry), is nearing zero (see my blog post). Many people, if not most, who are dependant upon government retirement money are victims.

Most importantly, the facebook guy had the cause and effect backwards. While it is true that there are some people who duck personal responsibility, at least in America that percentage is a minority. It is also true that some people are misled by the claim that their forced savings by the Social Security tax, for example, does lead to some level of personal protection at retirement. Neither type of group explains the large numbers of people who end up dependent upon Social Security.

What does explain those figures is the consequences of government actions in the economy. Just to point the finger at one element (out of a list of hundreds), look at the disconnection between savings and capital entailed in the policies of the Federal Reserve Board. The Fed thinks that the economy works best with an annual increase of price levels at two percent. This means that in just ten years, a dollar loses well over twenty percent of its purchasing power. At the same time, the Fed has driven interest rates down to very low levels. The interest rate offered by the standard savings account will not allow the saver to keep up with price inflation, especially after income taxes. To try to make ones savings work and grow, people have been forced to become investment professionals. However, the Fed’s policies have resulted in asset booms that have in fact left Americans with considerably less wealth.

The facebook guy is blaming the victim for the consequences of government actions.

Ayn Rand didn’t write about this issue directly. But she was asked about it. One response is on point. She was asked about unemployment insurance. The questioner clearly expected that Miss Rand would condemn the person taking the government money, but she didn’t. She said, “Government controls create unemployment. No matter what happens to your employer, if you are out of work today, why should you protect him and starve? There cannot be individual responsibility for something that is the government’s fault. In any situation where the government creates a hardship that pushes you into a position of martyrdom, you are morally justified to take advantage of whatever money is offered to you, provided you don’t spread the kind of ideas that created the trouble.” (Ayn Rand Answers, p. 124) (Note that Ayn Rand kept her wealth earned from her writing in savings accounts.)

Fundamentally, we are not individually responsible for the consequences of government actions. Nor can we hold other individuals responsible by demanding that they suffer when they are victims. In a society that is attacking the innocent, we are now in a lifeboat context, and the rules of morality apply differently. Condemning the victim, the innocent, is joining the government. It is corrupt. It is evading the cause. It makes finding the correct solution nearly impossible.

If we tell someone who can’t find a job because of government interference, say minimum wage laws or restrictions starting a new business, that he isn’t taking personal responsibility, we are doing the liberal’s job. We need to be telling him that he, too, is a victim. If he is to have a future he needs to live within capitalism.

If we then tell someone who wasn’t able to save for retirement and sees the cost of living and their medical expenses rising beyond reach that they didn’t take personal responsibility, we are doing the liberal’s job. We need to be telling him that he, too, is a victim. That if he is to be able to live, and even enjoy his old age, he needs to live within capitalism.

If we then tell someone who is poor and uneducated that they are failing to take personal responsibility, just because they are poor and uneducated, we are doing the liberal’s job. We need to be telling him that if he does not want to remain poor and if he wants an education of any kind, he needs to live within capitalism.

The only other option besides capitalism is a declining economy and ultimately depression and perhaps the collapse of civilization.

Let’s keep the cause and effect clear. Let’s not advocate policies that will further harm the victims. For example, declaring that we must first stop the entitlement programs before we have a functioning economy (meaning one that can create wealth) only means that we are telling people that they will have to suffer without hope. Yes, there will be some suffering in any event. But telling anyone that will have to suffer is only justified if we are moving toward capitalism, which means a free economy. So first we have to liberate the economy. Then we can cut the entitlements. But if we don’t begin with freeing the economy, we will only add suffering without the possibility of a prosperous future.