Predictably, there was a storm of outrage from savers and their representatives. This tweet is typical:
What Mark Carney said today is "Savers, I will continue to STEAL your money, as Mervyn King did", for the chancellor. #newsnightThe idea that very low interest rates is "stealing" from savers is based on savers' expectations that: their capital will be protected from inflation. UK CPI is indeed running above the interest rates on most forms of savings, so savers are losing money as the purchasing power of their capital is eroded. But is it reasonable for savers to expect that the purchasing power of their capital should be preserved, or even increased, over time?
— liarpoliticians (@liarpoliticians) August 7, 2013
I don't think it is. But to explain why, I need first to explain what inflation is.
In an economy where the money supply adjusts to economic needs*, the inflation rate is a measure of the excess of aggregate demand over aggregate supply. It is healthy for an economy to have a small excess of demand over supply, as it gives an incentive to producers to produce and consumers to consume: persistent disinflation is economically damaging, as the tendency of consumers to delay spending in the expectation that prices will fall reduces sales, depresses business income and can drive producers out of business, causing fire sales and layoffs, leading to more delayed consumption and further price falls - it is all too easy to see how this can become a deflationary spiral. But a positive inflation rate, even a small one, means that savers suffer erosion of their capital over time. The interest rate on savings is a compensation for that loss.
In an open economy, the inflation rate is not always a good indicator of domestic aggregate demand. It may indicate the extent to which demand for goods (especially commodities) in the international marketplace exceeds supply, and that affects the cost of domestic production, driving up prices to consumers especially for essential goods such as food and energy. It may also indicate fiscal tightening, as rises in indirect taxes such as VAT increase headline CPI. And it may indicate that the international purchasing power of the currency is reduced (devaluation): sterling has devalued by about 25% since 2008. The inflation rate for consumers can therefore be higher than the actual productive capability of the economy. This is what is happening in the UK at the moment. Inflation is running above target, at about 2.9%, mainly due to price rises in imported goods (notably fuel), which are partly due to the low pound (larger image here):
But the economy is growing at much less than this. Estimates vary as to the GDP growth rate at the moment but the last figure from ONS was 0.6%, which is just above the Bank of England's base interest rate, and economic growth has been hovering around zero for the last three years (larger image here):
This is dismal. It is stagnation, not growth.
So why shouldn't savers be protected from the capital erosion caused by inflation?
There are three categories of savers:
- those who are saving for something that they expect to buy in the future
- those who are storing up funds as insurance against loss of income
- those who have more money than they need for consumption at the moment.
The second of these involves the largest number of people, though perhaps not the largest amounts of money. These are people saving for retirement and for unexpected future expenses. The savings are long-term - often 30 years or more. Now, I've noted already that it is healthy for an economy to have a small positive inflation rate. Given that for savers to have a return on their savings AT ALL requires a healthy economy, I don't see any reason for savers to expect to be compensated for the natural erosion of purchasing power that exists in a healthy economy. It's a necessary cost of saving. They just need to save a bit more to allow for it, that's all. Alternatively, if people feel strongly that they should be compensated for inflation, index-linked investment products are available for longer-term savings. They will pay a bit more for them, but their capital will be protected.
But what if inflation is higher than the amount needed to keep the economy humming along? Shouldn't savers expect to be compensated for this? Not necessarily. We would normally expect that higher inflation would cause interest rates to rise, which compensates savers for the greater loss of purchasing power. Raising interest rates increases the cost of finance for businesses and households, which causes them to defer business investment and consumer spending. In an economy that is experiencing inflationary pressures due to fast growth, this is a good thing: but for an economy that is stagnating, businesses deferring investment and consumers deferring spending is disastrous. This is why "stagflation" - the combination of high inflation and a stagnating economy - is so poisonous. Raising interest rates to choke off inflation destroys desperately-needed economic activity, delaying recovery. And stagflation accurately describes the current state of the UK economy.
The desire of savers to be compensated for loss of purchasing power is understandable but wrong. The risk-free rate of return is related to the growth rate of the economy, not the inflation rate. Savers have no right whatsoever to expect to receive a higher rate of return than the ability of the economy to generate that return. If the economy is growing at 0.6%, the risk-free rate of return cannot be any higher than that. If savers want higher returns they have to put their money at risk.
At the moment savers have unreasonable expectations. They expect to have returns on their savings far above the current level of economic growth, and they also expect to have their savings protected from loss. But the only way savers can have risk-free returns above the growth rate of the economy is by others - most likely government - taking on debt. It's rent-seeking, frankly. I find it extremely odd that the same people who clamour for higher interest rates for savers are also those who shriek about the deficit and warn about the dangers of high levels of government debt. They clearly don't understand that higher interest rates for savers in the present climate means a larger government deficit because of increased cost of interest service on risk-free investments (government bonds). Or if they do understand, they don't care.
And while I'm at it, I shall criticise those who want higher interest rates on bank deposits, too. Bank funding costs have a direct bearing on the cost of finance to the wider economy. Interest rates for SMEs are already cripplingly high despite bank funding rates being low. If interest rates on deposits rise, what do you think will happen to interest rates for the small businesses that we so desperately need to encourage? Really there is a logic fail here. In calling for higher interest rates, savers are effectively demanding that there should be no recovery. And in killing off such unreasonable expectations, Carney is doing us all a favour.
What we need is for savers to take risks with their money. Now there is a bit of a problem here, I agree. The "reach for yield" in capital markets caused by low interest rates and excess liquidity is leading investors to switch into all manner of high-risk investments, such as sub-Saharan government debt. I regard this as excessively risky to the point of imprudence and it is NOT what I mean by savers "risking their money", any more than I would recommend that they blow it all at Aintree or on the casinos in Las Vegas. When I say I want savers to "risk their money", I mean productive investment in their own economy for a future return - for example, in the small businesses I mentioned above. I would like to see government, including local government, issuing bonds to savers to finance long-term infrastructure and energy projects. I would like to see expansion in local investment banks and credit unions providing finance to small businesses. And I'm very encouraged by the growth of internet providers such as Funding Circle and CrowdCube bringing together small investors and businesses who need finance, crowdsourcing both debt and equity.
Obviously there are some people who need their savings to be as close to risk-free as possible - "rainy day" savings for example. I think there is a role for government in providing genuinely risk-free savings opportunities for those who need them, and recycling the funds into the economy via a State Investment Bank. But these savings, and other protected savings such as insured bank deposit accounts, should only bear the risk-free interest rate.
I've heard it argued that interest rates on savings should actually be above inflation because savers expect to be compensated for their decision to defer consumption into the future. I'm afraid I think this is utterly bonkers.Whatever the reason for saving, it gives current benefits (in econospeak, "utility") as well as future ones. If your reason for saving is to avoid paying the interest on debt, then there is satisfaction from knowing that the interest cost is avoided - and there may also be a moral satisfaction from having "saved up" for something. If your reason for saving is to insure against future loss of income, you will derive comfort from knowing that your future is secure. And if your reason for saving is that you already have four yachts, sixteen cars and a house on every continent and you can't think of anything to buy, well frankly I don't see why you should be compensated for the fact that you have more money than you know what to do with. Do something useful with it. Invest it in a small business. Give it to someone who needs it. Spend it on desperately-needed medical supplies in a poverty-stricken country. Get some "utility" from using your money to help others. You don't need it, you can't take it with you, and you certainly don't need compensation for not spending it. Really.
And finally. I really don't hate savers, but I do think they need to be more reasonable. And I do have some sympathy for those who expected to use the income from their savings to top up their state pensions, and are feeling the pinch because that income is much reduced. However, the idea that these are "poor pensioners" is wide of the mark. The majority of pensioners live on the basic state pension and additional benefits, and they are not affected by this. The pensioners who are feeling the pinch are the better-off ones, the ones who have corporate and/or personal pensions and maybe other savings too in addition to the state pension. So I'm not impressed with the "poor pensioners" argument. The poor pensioners are those getting by on the basic state pension. This lot are poorer than they expected to be, but compared with the majority of pensioners they are not poor. And I have to ask why people who are living on unearned income from savings should have their incomes protected when people who are living on earned income - many of whom are too poor to save for retirement - do not. The people who have seen the largest falls in their real incomes in the last five years are not people living on unearned income (savings or benefits), but people who are working for their living. When will I see some concern from savers - or more accurately, their representatives - for the people whose incomes are being squeezed by unemployment, under-employment, falling wages, inflation, tax rises and benefit cuts?
(heavens, all of it Scripture-based!)
The golden calf - Coppola Comment
The foolish Samaritan - Coppola Comment
The parable of the rich fool - Luke 12:13-21, NIV
Added 10th August 2013:
The symbolic importance of NOT raising interest rates - Tomas Hirst (Pieria)
* In an economy where the nominal amount of money in circulation is fixed - such as a strict bullion gold standard - it is normal for prices to fall over time (disinflation) if the economy is healthy, since economic growth coupled with a fixed money supply causes the purchasing power of money to increase.