Friday 6 April 2012

More savings myths debunked

1. The point of saving

When people talk about "saving" it's usually in warm and glowing terms and while holding out a hand for subsidies, but as ever, they are only looking at one half of the equation, i.e. the "not spending" and "building up assets" bit. The point of saving is not to build up assets, and saving still makes sense even if you get no investment returns at all. Saving still makes sense even if high inflation/low interest rates are eroding the value of your savings.

The point of saving is actually to spread consumption over time, and more than that, it's about maximising the value of consumption to yourself*. You could, if you wanted, take your monthly salary and go on a three day festival and then live like a pauper for the rest of the month, but most people find that they are happier if they spend (or consume) roughly the same amount every day or every week.

The same applies on the level of a lifetime, there will be times when you dis-save (when you're not earning money - by spending your savings or getting into debt) and there will be time when you save (by earning money and putting cash to one side or paying back debt). From the point of view of each individual, the ideal net savings minus dis-savings ratio over a lifetime is precisely nil (even better is to die in debt, but you'd have to time it right).

There is also the point that, apart from land prices in a Home-Owner-Ist system, most things get cheaper over time. If you wanted to buy a PC for £2,000 in the early 1990s but could only afford to save £10 a month, it would not have taken you 200 months to save up, because after 100 months, the price of a PC fell to £1,000. And you started saving up £10 a month towards a PC ten years ago, it would actually only have taken you 50 months to save up for an even better PC which by then only costs £500.

So when politicians wail on about the UK's low savings rate, they are missing the point. If the ideal net savings ratio for any individual over a lifetime is nil, then the ideal aggregate for the whole population, some of whom will be saving and some of whom will be dis-saving at any one point in time is also nil.

* The fancy terms used by economists is "marginal utility of consumption", people (usually) get the most happiness from the first few units they consume of anything and it gets less and less after that. If you like apples and spend £2 a week on a bag of nice apples, that's because eating one apple a day gives you (more than) £2's worth of happiness a week. But you would not spend £2 a day on them and force yourself to eat half-a-dozen every day. That would give a lot less than £2's worth of happiness a day.

Another way of looking at it is that rich people get much worse value for money. Instead of spending £8 a month on bags of supermarket apples, they might buy a single apple from a special Fair Trade farm run by African orphans of land-mine victims. Yes, this special apple might taste a bit nicer than yer supermarket apple (and give you the warm glow of righteousness), but only a bit.

In the same way, you can buy a perfectly usable second-hand car for about £2,000; for £20,000 you can buy a new one, which smells nicer, uses a bit less petrol and has all sorts of gadgets in it; and if you spend £200,000 you can get something really fancy (but probably completely impractical). But somehow I doubt that the man across the road gets a hundred times as much happiness from his Lamborghini than I do from my Mark II Golf.

2. Saving is not the same as investing

If we assume a clear split between 'households' and 'businesses' (there isn't of course, but it makes thinking about it easier), the reason why households and individuals save is to spread consumption over time. The ideal overall 'savings ratio' is nil. Of course, if you can earn interest on your savings (or any other investment return), that increases the amount that you can consume over your lifetime, so hooray. But the extra consumption you can afford because of investment income is a bonus and not a feature.

When businesses invest, this has the specific purpose increasing future production capacity, by and large, most of this is (or could be) paid for out of retained profits. The ideal 'investment ratio' for businesses is hitting the correct trade off between e.g. spending £1 billion on making 100,000 cars a year using the existing production line, or spending £1 billion on a brand new production line which is more efficient and can be used to manufacture 150,000 cars every year in future once it's finished.

That is real 'investment', there is no such thing as a negative production line. But when you buy shares in that car manufacturer in the hope that the decision to build the new production pays off, this is something quite different, assuming that the production line was paid for out of retained profits anyway; if you buying shares is 'investing' then whoever sold you the shares is clearly 'dis-investing', and this is not net investment in anything.

3. Home-Owner-Ism is anti-saving

As we have established before, taking out a large mortgage early in life in order to live in the largest possible house is not saving; it is dis-saving (running up debts is the opposite of saving). Living in a larger house, compared to living in a smaller house, is not saving, it is consumption. For sure, paying off a mortgage is a type of saving, but even better is to take out a smaller mortgage and to pay it off more quickly; once paid off, the extra spare cash you have which you no longer need to pay off the mortgage can be used for real saving.

There is also the wealth illusion. The Homeys believe that when land prices go up, they are getting richer, so they save less and do mortgage equity withdrawal. They are consuming more now in the hope that whoever buys the house from them will pay a much higher price, in other words, they are hoping that future generations will save even less.

As we see, the savings ratio drops when house prices are rising and recovers when house price bubbles pop again:Data from the ONS.

For sure, part of the reason why the savings rate jumps during recessions is because people tighten their belts, but what if house prices stayed low and stable? Then people wouldn't be able to do mortgage equity withdrawal (which is quite clearly dis-savings) and which adds about six per cent to people's disposable incomes (i.e. increases consumption) during house price bubble years: Chart from Duncan's Economics Blog.


Tim Almond said...

"In the same way, you can buy a perfectly usable second-hand car for about £2,000; for £20,000 you can buy a new one, which smells nicer, uses a bit less petrol and has all sorts of gadgets in it"

Not even sure that there's many new gadgets nowadays. I'm looking at a 5 year old 5 series, and it's got everything down to heated door mirrors. I can't think of anything to add into it. I'll live without the new car smell to get it for 35% of the new price.

(don't really want a beemer, just want a huge estate car and the other options don't seem any better).

A K Haart said...

We treated our savings in exactly this way.

We took on lower mortgages than we could afford with the intention of eventually leaving work in our 50s to do other things while living off savings for a few years. Which is what we did and never regretted it.

Mark Wadsworth said...

TS, a lot of people HATE these new gadgets (certainly I do) but the motor companies must think that people like them, and assuming the motor companies are not totally thick, a lot of people must like them.

AKH, exactly. The problem is that history shows that up to now, you'd have been better off maxing out on the mortgage on the biggest house possible and then cashing in and trading down a couple of years ago. The whole system is geared up to rewarding over-consumption of housing.

Bayard said...

"I'll live without the new car smell to get it for 35% of the new price."

Surely someone has produced "that new car smell" in a handy aerosol can by now?

Derek said...

Good analysis, Mark. I hadn't thought of savings in that way. It makes a lot of sense.

Mark Wadsworth said...

B, good idea. My wife has those little scented trees hanging from her mirror - to me they smell like "new car" but only by association, but there's probably a market for little trees which actually smell like "new car".

D, glad to have been of help.

Curmudgeon said...

Isn't another purpose of saving being able to leave a legacy to your children?

Mark Wadsworth said...

C, if that's what you want to do, then do it. It strikes me that the best thing you can do for your kids is bring them up right, give them a happy childhood, get them the best education or training that's suitable and not get on their nerves too much when you go to visit at Xmas. Anything more than that is the futile quest for immortality.

Sarton Bander said...

Seeing what the trustafarians get up to. Handing over money to your children without any accompanying work is probably the worst thing you can do to them.

Bayard said...

IMHO, the worst thing you can do to your children, inheritance wise, is, at an early stage, give them an income that is just enough to live on, thus removing the need to work, but not enough to live on comfortably, thus ensuring a fairly miserable or debt-ridden existence and leaving them prey to passing fortune hunters/gold diggers.

TheFatBigot said...

You can get "new car" aerosols, I can't remember the brand name but will let you know if it comes to mind.

I'm glad to see you now accept that buying a house is a form of saving despite having to denied it last week.

Something that can be done to increase the savings element is to take a mortgage less than you can afford and over-pay each month. The loan contract will determine how overpayments are treated, usually repayments must be on £5k or £10 lumps so the bank keeps the money and reduces the capital sum owed once you have reached the magic figure, but they often treat the overpayment as though it earned interest at the mortgage rate.

Mark Wadsworth said...

TFB: "I'm glad to see you now accept that buying a house is a form of saving despite having to denied it last week."


I showed quite clearly that housing is consumption like anything else and taking out a mortgage is dis-saving, by comparing Mr A and Mr B who bought a large house and a small house respectively. and you know it. Unsurprisingly, Mr B ended up with more savings.

It is paying off the mortgage that is a form of saving (well actually it's negative dis-saving, but that comes to the same thing).

Lola said...

Excellent. And as I keep telling my 'peer group', that very few of them are anywhere near as good 'financial planners' than a lot of their clients.

Proper capitalism does more for less every day and allocates savings/investment on average more efficiently than any politician/bureaucrat.

Lola said...

On the 'marginal utility of consumption' thingy, I have observed that personally I can go on 'consuming' active participation in motor sport until I am too knackered, not bored or even getting less enjoyment...but then it is a 'passion'......or am I just an 'addict'? (This can be confirmed by polite enquiry to Mrs Lola - don't expect a reasoned ar calm response).

Mark Wadsworth said...

L, yes, I suppose addiction is a mathematical aberration of marginal utility/diminishing returns to scale.

If a normal person has had his apple or two a day, he stops eating them, because he derives little or no pleasure from the third, certainly not 20p's worth.

But if you are addicted to apples, you think that maybe you can defeat the law of diminishing returns by buying ever more expensive apples, like the hand polished Fair Trade one for £8. But you don't enjoy it, so you splash out £20 on an Indonesian micro-apple from a tree which only flowers once a decade, and which you can eat in a single bite, and so on.