The problem with households not saving is that over the long run, it ruins the economy.

Lack of savings means there are not enough long-term private bank reserves. Broadly, it translates into lack of investment in new business capital. Over time, that runs down the capital base of the economy. And improving business capital is, of course, the key to increasing productivity within an economy.

If productivity doesn’t increase, wages and living standards will stagnate – at best. Eventually, living standards decline. Don’t believe me? Have you been to Detroit lately?

Decades-Long Trends

Last year’s lack of savings was not a short-term phenomenon. The savings deficit was part of a long-term cultural phenomenon. The low savings rate in 2008 was one more data point in a string of many bad years for savings.

The personal savings rate in the U.S. makes for an interesting chart (see below, for 1930 to the present). The first thing that pops out is that savings were very high (near 25%) during World War II, when there were few consumer goods available to purchase.

All that wartime saving had much to do with kick-starting the U.S. economic explosion after the war ended. While the war was raging, many economists expected a postwar crash. That’s what had happened all the way back to the days of Napoleon.

In fact, the prospect of postwar mass unemployment, involving millions of demobilized soldiers, was one of the key drivers behind creating the G.I. Bill of Rights. It was better to send former soldiers off to college for a few years than to have them sitting around with no jobs, muttering into their beer mugs.

Instead of a postwar crash, however, the large pool of U.S. aggregate savings aligned with pent-up demand to spark a historic economic revival. In the 1950s and into the 1960s, the World War II generation settled down to raise its baby boom offspring. While savings rates cooled down, they still averaged a very respectable 8.5%. And this was in an era of very low inflation.

The national savings rate actually increased toward 10% during the 1970s and early 1980s. But from the mid-1980s onward, the national savings rate declined steadily. The rate was in the low single digits – and falling – by the early 2000s, and went negative in 2006 and 2007. For the U.S., these recent numbers were the lowest savings rate since the Great Depression.

What Was Going On?

Let’s review some large-scale trends that occurred during the past four decades. Starting in the 1970s, many women entered the U.S. labor force. More accurately, women exited the unpaid world of homemaking and entered the paid labor force.

The demographic shift of women into the labor force started as a trickle, but turned into a flood. Indeed, over the past 30 years, many traditionally male-dominated occupations and professions opened wide for women to pursue careers. Enrollments in U.S. law and medical schools, for example, are now well over 50% women. Just this year, over 50% of undergraduates majoring in earth sciences in the U.S. are women.

More women in the work force led to a fast-growing number of two-income households. But as pointed out by Elizabeth Warren, a professor and bankruptcy specialist at Harvard Law School, those extra paychecks often went to consumption, rather than savings.

For example, working couples took the second paycheck and bought a second car, if not a second house or condo. Working couples took more high-end vacations, as you can observe by driving past the cruise ship terminals at most major U.S. port cities. And the average size of new homes has increased during the past 25 years, even as average family size declined from over three to about 2.1 children per couple.

In short, Americans saved less over the past 35 years. But U.S. consumer spending took off and grew faster than the broad economy. Consumption accounted for 62% of gross domestic product (GDP) in the 1960s. But consumption grew to 70% of GDP between 2000-2007.

Looking at the numbers another way, “investment” in the economy plummeted from 38% of GDP to 30% – a drop of over 21% from the 1960s baseline. So it makes sense that much of the increase in consumption in recent years was of imported goods. Thus did high consumption and low savings help to decapitalize the nation, as trillions of dollars wound up in foreign accounts.

And Then What Happened?

With high consumption and low savings, when the current recession hit, it hit hard. In fact, the effects of the recession were aggravated by the national pattern of high consumption and low savings over the past decades.

Let’s begin with the fact that many households spent every dollar that came in. Then they borrowed against the so-called “equity” in their house (often as not, the equity was mostly a product of inflation) to finance further consumption. But there’s a funny thing about borrowing money. Usually, the lender wants it paid back.

As Harvard’s professor Warren has pointed out, many two-income households painted themselves into a “two-income trap.” That is, when both wage-earners devote their entire paycheck to consumption, with nothing going into savings, the loss of one job can be a financial catastrophe. A household at the margin almost instantly goes underwater.

Also, it’s becoming clear that in the past year, many job losses in the U.S. economy are permanent. Instead of temporary layoffs, many jobs are being eliminated as part of a structural retrenchment of the U.S. economy. Think about the job losses in the auto and auto parts industries, in banking and finance, or in real estate. Many of these jobs are just plain history. These industries will never recover to the glory days of old.

Along these lines, a recent survey conducted by The Wall Street Journal reveals that 52% of companies polled expect to employ fewer people over the next five years. That can hardly be reassuring to the rapidly expanding ranks of the unemployed in large states like California, Michigan, Illinois and others. Big states with large numbers of jobless people make for big, long-term, intractable social and political issues.

The “Recovery-Less Recovery”

So the job cuts, and long-term unemployment, are here to stay. Much of this has to do with the previous lack of savings and long-term investment. After two decades of falling savings, and related underinvestment in new business capital, there is not enough momentum within the job-creation engine of the U.S. economy. The machine is stalled.

It’s not like you can accelerate the process of job creation, either. Sure, government can spend a lot of money (borrowed money, as it turns out) in a hurry on so-called “stimulus” programs. But what will that accomplish? People still can’t find long-term employment – let alone careers and employment security – in industries that don’t exist or never took root. Nobody gets hired in a firm or factory that never got built. So now we’re experiencing what many economists are calling a “jobless recovery.”

Jobless recovery? That might be whistling past the graveyard. Indeed, the lack of job creation going forward could also lead to a “recovery-less recovery.” Or to paraphrase former President Richard Nixon, speaking of the idea of Keynesian economics, we’re all living in the Rust Belt now.

Some Households Are Saving Again

There is some good news from the savings front, however. As 2009 unfolds, it appears that debt-burdened American households are desperately beginning to save. In April 2009, the national savings rate jumped to 5.7%, the highest level in 14 years.

Still, savings has to come out of something else. Households “saved,” but the other side of the coin is that “consumers” ratcheted down their spending – and did so even faster than aggregate incomes fell. That means empty shopping malls and auto lots. It’s a vicious cycle.

“Americans have learned a cruel, cold, hard lesson,” according to Bernard Baumohl, an economist for the Economic Outlook Group of Princeton, N.J. “People are scared. And that’s led them to replenish their savings because they now realize that their retirement nest eggs will no longer increase on automatic pilot.”

There’s no disputing the extraordinary shock to household wealth in the U.S. From mid-2007-March 2009, according to the Federal Reserve, household net worth plunged $14 trillion, or 21.5%. Just during the second half of 2008, household net worth plummeted nearly $8 trillion – with an eye-popping $4.9 trillion dip in the fourth quarter.

Meanwhile, the broad-based Standard & Poor’s 500-stock index shed 57% of value between October 2007-March 2009. While the S&P 500 has increased 36% since its March low, it is still 41% below its 2007 peak.

According to Mr. Baumohl, the economist, “There has been a fundamental shift in the behavior of American households.” That is, savings are now a priority of financial planning. Mr. Baumohl believes that we’ll continue to see the savings rate increase to between 7-9%, where it will likely hold steady for at least several years. Many of the 75 million baby boomers are now revising their retirement plans, figuring out how to work longer, save more and spend less. (Meanwhile, the federal government is working to figure out how to pay lower Social Security and Medicare benefits to those baby boomers.)

All in all, we should expect to see U.S. consumer spending grow more slowly than GDP over the next decade. As a percent of GDP, investment will increase as some fortunate households replenish savings. But any recovery will be slower than most observers expect – particularly the politicians, who cannot abide large numbers of unemployed people near Election Day.

Rooting for the Savers

The good news is that over the long-term, more savings will translate into more business investment. That should create new jobs and raise productivity, which are the basic building blocks for a rising standard of living.

Of course, there are problems with any significant shift in the direction of capital flow in the U.S. economy. But despite any issues, the unemployed of the U.S. need to root for the savers. And the politicians, of course, need to respect the process of saving. Because without those savings, the economy will continue to wind down.

And what if the political rhetoric descends into class warfare? What if the savers of the nation become objects of ridicule, subject to punitive levels of taxation and regulation? In that case, we get back to the idea that capital is portable.

If savings cannot find a safe harbor in the U.S., then the capital flows will keep moving offshore. And if that happens, all bets are off for the U.S. economy. We can just sit back and listen as the band plays “Nearer, My God, to Thee.”

Until we meet again,
Byron King

July 2, 2009

Too Much Spending, Not Enough Savings: Destruction of an Economy was originally featured on Whiskey and Gunpowder

Innovation, Savings, and Demand

“From a fishhook to the space shuttle, every material human advancement has been the result of a combination of technological innovation and capital savings. In other words, we are now building on the savings and innovation of our ancestors.”  — Victor Sperandeo, Trader Vic II: Principles of Professional Speculation

THIS PAST WEEK, the April issue of MIT’s Technology Review hit my desk. Its cover story this month is “World-Changing Ideas…25 Innovations From Around the Globe.” Among the more interesting:

What do these developments have in common? They are all focused on natural resources, and they highlight the intersection of three key forces that form the heart and soul of capitalism. What are those three forces? Drumroll, please…they are innovation, savings, and demand.

• Brazil is making a major commitment to biodiesel, an oilseed derivative with strong potential as a long-run alternative to fossil fuels.
  
•  In China, Shanghai’s Solar Energy Institute is focused on advanced solar technology. The ultimate goal: a home with 70% of energy needs met by the sun.
  
•  Chile hopes to increase its copper reserves substantially through genetic advances in biomining, a process that uses bacteria (rather than noxious heat or chemicals) to extract copper from the ore.

Let’s go over them briefly, because a proper understanding of these forces is imperative for investing success.

The Heart and Soul of Capitalism: Innovation

Innovation is perhaps the most intuitive of the three forces, but it is still overlooked or misunderstood. Through innovation, we become more productive and are thus able to reap greater output from the same or less input. In a rare instance of serendipity, the innovator is able to increase his wealth while increasing the productivity of others at the same time. The first fisherman to use a net would have had substantially greater numbers of fish to trade relative to his peers, without exerting greater effort. Once the idea caught on, greater quantities of fish would be available to the benefit of all. Alternatively, if greater quantities of fish were not desired, then fewer fishermen would be required to bring in the necessary catch, allowing some of them to pursue other productive pursuits. With every additional innovation, we are given the beneficial choice between greater levels of output or a surplus of resources available for alternative pursuits. And so we continue trading up to the present day, where the innovative fisherman’s descendants find themselves engrossed in solar energy and biomining.

Down through the centuries, innovations have shaped history and accelerated progress in sudden jumps. The plow led to agriculture-based societies rather than hunter-gatherer ones, which in turn created the locational stability required to build cities. Gunpowder led to the demise of feudalism and the first stirrings of democracy by bringing cheap weaponry to the masses. The printing press fueled the Protestant Revolution, which in turn sowed the seeds of Western-style capitalism.

This highlights another characteristic of innovation, namely, its incredible disruptiveness. When a promising new idea changes things for the long run, there are always vocal protesters in the short run. The term “Luddite” honors the memory of Ned Lud, a noted loser in the innovation process, who led mobs of workers in the destruction of British textile mills between 1811 and 1816 out of fear that they would destroy jobs. Ned has many descendants, in spirit if not in blood, and they are equally vocal today. Unfortunately for Ned and his descendants, the short-term pain of disruption is unavoidable, and in fact vital, in the pursuit of progress. In 1942, Joseph Schumpeter immortalized the concept by coining the phrase “creative destruction.”

The Heart and Soul of Capitalism: Savings

Savings are required to pursue innovation. Innovation is essentially an investment in future production, and one cannot make an investment without savings. This investment does not have to be in the form of money. It can be time, energy, education, other opportunities forsaken, or a number of other things. And like any investment, there is risk involved. When our intrepid fisherman first conceived of the idea for his net, he had to make a number of investment decisions. Was this idea worth pursuing in terms of energy and effort? Could he afford the time taken away from his regular fishing day? Did he have access and means to acquire the necessary materials? Would he have to budget time for trial and error as he tried different weaving patterns in the construction of the net? Was it worth the opportunity cost of foregoing other avenues of production? All these questions go back to savings (in the form of human capital rather than fiduciary), and a willingness to put a portion of those savings at risk. Without an available surplus of time, energy, and resources, the net would never have seen the light of day.

The immutable relationship between savings and innovation is now clouded because there are so many hidden links in the chain. Thanks to the modern application of credit, it’s tempting to forget that savings are still required to innovate. After all, don’t entrepreneurs borrow money to start businesses every day? Indeed they do…but it is still someone else’s savings they are borrowing (and putting at risk), as well as their own time, energy, and opportunity cost. Ah, yes, but what about fractional reserve banking and the stimulative “easy money” activities perpetuated by the Federal Reserve? Even here, the circle remains closed. When excess liquidity is pumped into the economy, it only serves to devalue the real savings that previously existed, like a watered-down drink not worth the inflated price.

Coincidentally, America’s great hope is that we will innovate our way out of the current savings straits. In essence, bulls are betting the next long cycle of innovation will pay off big enough to cover the current tab. No matter how you slice it, savings are still required, be they already earned or mortgaged against the future. The only problem is we aren’t investing our borrowed funds in ideas, education, and means of future production; we are loading up on DVD players and SUVs while our next generation’s education rankings slip down the board.

The Heart and Soul of Capitalism: Demand

Demand is where the rubber meets the road. Without it, the innovations produced by way of savings have no benefit. In the case of natural resource development, demand usually comes first, spurring innovation through a sense of urgency or a clear long-range price advantage. When it comes to consumer innovations, like ATMs or iPods, the innovation usually comes first, with demand to follow once the value of the new technology or process is widely recognized. Either way, demand is the catalyst that ultimately allows the innovation to bear fruit. 

Demand is also important enough to stand on its own as an investment concept. As an investor, you can earn your keep simply by gauging fluctuating levels of demand properly. This, in fact, is how fortunes are made in commodity markets. By recognizing critical periods when demand is set to significantly outpace supply for a long period of time (or vice versa), it’s possible to make a great deal of money as prices wax and wane. The same applies to business expansion, in terms of applying a successful idea to a new city, region, or country. We don’t have to reinvent the wheel to make money; in fact, we don’t even have to improve on the wheel. All we have to do is uncover market opportunities where rising demand for wheels has not yet been met.

Of course, there are multiple factors that have to be taken into effect when considering potential demand. Among them are the level of competition, the economics of production, logistics of delivery, comparative substitutes, political risk, barriers to entry, potentially disruptive innovations, and so on. But when it’s all boiled down, the heart of the matter remains relatively simple. Economics deals with the allocation of raw materials and finished products that exist in limited supply, be they crude oil deposits, atomic physicists, or iPods. Demand is the root of the equation.

In part II of this series, we will take a closer look at innovations and economic factors in the world of natural resources. Through this lens, we will uncover some of the predictable ways in which innovation, savings, and demand tend to interact over the long cycle…and see how we can directly apply these observations in our relentless pursuit of profit. “The Death of May, 12 October 1949

And of course, comments and observations are sought with extra emphasis this time around, given my relative newness to the Whiskey & Gunpowder community. Let me know what you think – simply reply to this e-mail!

Justice Litle
March 23, 2005

“In the early summer of 1949 my daughter graduated from the Madeira School in Virginia, and shortly afterwards my wife and the children came to Switzerland, where we spent happy weeks at Pontresina and Saas Fee.  May said occasionally that she could hardly keep up with the children on walks; unfortunately, I paid too little attention to these remarks.  She was never ill, and I took that to mean that her health must be perfect.  In September she returned to Washington with the children, and I was to follow in November

“On 12 October, shortly after noon, May was stricken by a heart attack and died within a few minutes.  The two days that then followed must have been terrible for my children, who had been with their mother that morning; because of fog I was unable to arrive for two days.  I found the children grown up far beyond their years. 

“In my shock, I found myself questioning God’s will: why had my wife, who was so much younger than I, been torn away from me and the children?  Soon I came back to my senses.  Our marriage had brought me deep happiness in middle life.  I had to be grateful for that, bowed down as I was by present sorrow. 

“I pressed the children to me.  They tried to conceal their sorrow in order to comfort me.” 

The Heart and Soul of Capitalism: Innovation, Savings and Demand was originally featured on Whiskey and Gunpowder