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The Savings Paradox

The U.S. economy is in the throes of a recession whose severity will only be known once it has ended.This recession is the result of the collapse of the financial system, which raises the question: is it the collapse of the financial system that hit over-indebted consumers so hard, or did over-indebted consumers, crushed by an ever-increasing debt load, bring about the collapse of the system? It’s the old paradox of the chicken and the egg.

In 2005, the savings rate of Americans was negative: they were spending more than they were earning. Consumers were even dipping into their savings to maintain their lifestyle.Many Americans engaged in this risky practice because the value of their homes continued to rise. At that point, many analysts felt the situation was already dangerous.With more than 78 million Americans reaching retirement age in the near future, the upward spiral in real estate prices could not last.The Great Depression is the only period in history when the savings rate was negative. From the end of the Second World War until the early 1980s, the savings rate of the typical American family remained above 10%.

After 1981, interest rates reached a record high and then began to fall, encouraging Americans to save less and spend more.This was the beginning of what is now referred to as ”The Great Bull Market.” Note that the record highs on the S&P 500 coincide with lows in the savings rate. Already in 2006, warnings were issued that the bull market was supported only by excessive spending made possible by too low interest rates. It didn’t take a genius to see that a negative savings rate was unsustainable over the long term. And what was bound to happen did happen.

The current crisis will surely affect the average American’s propensity to spend. After the Great Depression, we saw a whole generation of Americans who considered debt a dangerous folly and who were obsessed with saving.The present crisis could have a similar effect on the behaviour of our neighbours to the south. In late 2008, the savings rate was around 1.3%; many economists now expect this rate to gradually climb to 8% over the next decade. Others believe Americans will become voracious consumers again once the economy bounces back. Many Americans, even younger ones, now realize that the onus is on them to prepare for their golden years, and that they will have to maintain a reasonable savings rate in order to enjoy a comfortable retirement. How long this change in behaviour lasts will probably depend on the length of the recession.

A higher savings rate is an excellent thing for an individual’s financial security, but it hurts economic growth.Consumer spending accounts for 70% of economic activity.

So the economy needs a low savings rate to pick up again, and consumers need a high savings rate to regain financial health.A return to savings is inevitable.The problem now is to figure out how long the situation will last, how long it will take for the rest of the economy to adjust, and how long it will take for the stock markets to reflect this new reality.

The author

Marc Desnoyers

Marc Desnoyers

B.Sc., M.B.A., C.F.A