Sunday, August 21, 2011

Can Negative Interest Rates Cause Savings to Increase?

At current interest rates, an individual will lose purchasing power in their savings account if there is even an inkling of inflation. A common assumption is that the Fed has done this (i.e. pushed interest rates to historic lows) to increase aggregate demand (i.e. if you are earning nothing, you might as well spend it) or to move investors to riskier investments that might provide better momentum for the underlying economy (i.e. an investment in a corporate bond that makes it cheaper for corporations to borrow).

But what if low to negative interest rates in fact causes the opposite... an increase in the savings rate and derisking by investors? This post is based on a very quick and dirty framework I've been thinking about and focuses on the savings rate, but the same framework could (in my opinion) justify why investors may choose to derisk as well. Any feedback would be greatly appreciated.

Getting to $100 Saved

Let's assume our saver knows that in ten years they will need to have $100 saved (for retirement, college education for their kids, a new car, etc...). Earning 0% on their savings, they would need to save $10 / year. If they were to earn a rate of return on that $10 saved each year, by the tenth year they would have excess savings (i.e. the blue and yellow lines).

As a result, if an investor can earn more than 0%, they do not need to save $10 / year, but a smaller amount. The chart below shows how much that $10 can be reduced based on various rates of return on their savings.

Assuming the individual earned $200 / year, the original $10 was 5% of their income (i.e. a 5% savings rate). The various amounts needed to save each year is converted to a savings rate below. It clearly shows that if a saver can earn a rate of return greater than 0% (i.e. if interest rates were higher), they can save less to get to their goal.

Unfortunately, savers aren't currently able to earn 0% on their checking / savings accounts. With any inflation, an investors is faced with negative interest rates. So, to get to a $100 real level of savings, an investors will need to save more than the $10 / year.

I know some readers will point out that an individual can always choose to add more risk to increase their returns, but what happens if that investment doesn't work out? An even higher level of savings, which they may not be willing or able to do.

So there's the very basic framework. What am I missing?


  1. Seriously good post. I came through Macrobusiness to your blog.

    Assuming you are correct that negative real interest rates increase savings, I might also add that the savings profile will be different for different age cohorts.

    The young might actually spend because they are not saving for retirement at all yet. But those in their 40s and above will be trying to 'rebuild their balance sheets' by saving even more, as you suggest.

    Do you mind if I cross post this entire article at my blog (with appropriate attribution of course)?

  2. Cameron- go for it. Everything on this site is for sharing (as long as attributed). Thanks.

  3. I think your post highlights some good points that show the problems of a liquidity trap where that condition is not expected to persist forever (ie where politicians and the people on CNBC, although not the bond markets, are forever warning of the impending hyperinflation. I will leave unsaid the easy explanation of a Keynesian solution.

    However, the important aspect you have omitted from your model is by subjecting your hypothetical person to existing debt. This will reduce the savings rate, but will also perpetuate the economic stagnation that is leading to the 0% interest rates on savings.

    Assume that he has debts of $50 at a 10% interest rate. Out of his earnings of $200, he is spending $10 per year in savings and paying $5 per year in interest. Needing $100 in 10 years, he can enhance his earning power by paying down the debt with $10 per year plus the $5 he would otherwise be charged interest on.

    Paying down debt is effectively generating a rate of return of 5% a year that, even if he had to re-borrow to meet the need, he would have earned 5% return by not paying the interest on the debt. Since he is earning 5% by saving through debt deleveraging, it is clearly beneficial for the individual to use their resources to save.

    However, that perpetuates the economic problems of the liquidity trap (the paradox of thrift) by focusing resources of individuals on reducing debt instead of spending, which reduces the aggregate demand of the economy.

    If there were 5% inflation in this situation, with rates at 0%. But the rate of return from repaying debt would drop to 0%, increasing the benefit to the individual from spending that money now (current consumption being preferable to future consumption).

    The debt would also drop in real terms by the rate of inflation, benefiting the consumer, probably in excess of the cost imposed by inflation on the individual as a saver. It also stimulates demand, which would benefit the economy now and help move the economy out of the liquidity trap that led to the 0% interest rates in the first place.

  4. Blake-

    Interesting point and I am a great example. I have too much cash tied up in my checking account, yet I'm not willing to use it to pay down my student loans (my rates are so low, I prefer the optionality of the cash even with the negative carry). If rates were to back up, I would be more willing to pay it down.

    As you point out, in a world of negative real rates, debtors benefit (another reason low interest rates and inflation is hugely beneficial to a debt burdened federal government all else equal). The issue is your aforementioned paradox of thrift and the fact that there are too many creditors (loosely defining savers as creditors) vs. debtors.

    Thanks for the comment.

  5. Your math is fine. THe only flaw I see is that while it's rational, 95% of all people (subjective hyperbole only) don't plan their finances beyond the next paycheck let alone 10 years out. And a money manager that really does understand this will never knowingly earn a negative rate, period. Unless we're in a deflationary period which would be a whole nother story.

  6. I agree that a money manager wouldn't park money is cash, but additional investments through a money manager is still savings.

  7. I agree with the general idea. As my income from "riskless" savings has dropped, my ability to survive hiccups in risky investments drops. So, to get back to an acceptable overall level of risk, I have had to cut back on risky investments. It's just common sense.

  8. Only an anecdotal story, but you described me. Still, I don't think I fit a normal profile. Currently age 56 and saving 40% or more of gross income for 13 years. Bad marriage can be as problematic for financial planning as a secular bear market. I've survived rounds of layoffs so far, but you can't count on a job in a cyclical industry. I have not planned on significant equity returns since 1998 and don't even plan on social security to fund my retirement. Zero debt and it will likely stay that way. My Toyotas stay in the family for 15 years. But I'm not a Spartan or a disaster day loony with a year's supply of soap and food in the basement. I plan for poor or negative returns for a few more years; work while I can; invest some when the market really sucks, but keep powder dry until the secular bear hints of an end.

  9. I think this is a brilliant piece of marketing. I don't know if you are in marketing but its very well done.

    In order to sell your product (here, your opinion) you have to proport reasonable assumptions (person sticks to saving regime) and simplify circumstances ($100 round figures, static rates over 10 years etc) in order to maxamise your audience (general public). you win peoples trust in keeping the assumptions reasonable and promptly making your point on savings/interest rates and how negative interest rates cause savings to increase.

    my constructive criticism here is similar to Anon, "in order to 95% of all people (subjective hyperbole only) don't plan their finances beyond the next paycheck let alone 10 years out" A static example struggles to reflect the dynamic reality, (but again, making static assumptions is necessary to your overall point). When Niall Ferguson gave a speech here in Sydney he referred to markets less like an orderly system (like political leaders sell us), more like an ant hill. Built up over time, stacked up relying on the existing foundation, with no long term structural foresight. Indeed a market is "a collection of individuals working toward their own self interest"

    But i feel your example re-enforces how dangerous the game of chicken the US federal reserve is playing with an increase in inflation by keeping rates at 0%. After the extreme instability of a subprime crisis (and as a natural tight-ass) my intuition would be to save. But as your example shows inflation actually makes 0% interest rates become negative. if your correct and 0% rates results in more savings, an increase in inflation could be a negative spiral, along with the 'paradox of thrift'.

    As cameron mentions 0% interest could benefit they young more than the old this will punish those with savings, rewarding those who take out more debt. Add any serious inflation to the mix and one would wish for a more static situation to the dynamic.

    referral Macrobusiness also.

  10. This blogger is confused because I'm not sure whether to feel insulted or complimented by the "marketing" comment as that implies I have been successfully in sharing my thoughts in a simplified manner (i.e. my goal of this blog).

    Anon followed with his own opinion, which does not seem to differ from my own idea of the issues in the system.

    Result = I am more confused.

  11. Jake, Definitely a compliment. I know marketing has negative connotation but what i meant was you relay the point well. Apologies for confusion and thanks for the post, have shared with friends etc.

  12. Oh good. Compliment accepted!

    As for the point that the average individual doesn't think 10 years ahead, I think this actually makes the issue worse. If they do not save more in year 1, 2, 3... then when they realize they need to save even more in year 4, 5, 6. If they didn't save enough by that point, they need to jack up their savings even more (or they choose to forgo what they planned to save for).

    I think in this analogy we are already in year 9. Individuals haven't saved nearly enough for retirement and are now in a situation where they can't save more in many cases.

  13. I agree with this theory.

    But I do not think it is based just on the level of Interest Rates or inflation. That may partially exacerbate the issue, but in general I think when confidence is gone, and the consumer starts saving, then it is very difficult to change her mind.

    Low interest rates do damage the savers which do react by saving even more; but they also do help the spenders and people with variable debt or in *need* of new debt. Help to a point. They do not necessarily promote strictly unnecessary new debt, because when rates are low so is confidence.

    And I guess that's why central banks are possibly more worried when deflation establishes itself rather than mild inflation.

    One final thought: is it really possible at all for a central bank to fight deflation just with monetary policy? It does not seem so.

  14. It's basically what I'm doing. If interest rates were higher, I could relax and spend more. But they're basically negative which means I have to hunker down and save as much as possible. Paid off the mortgage last month and currently putting additional cash (from paycheck) into savings. It doesn't help that stocks are so volatile either. I'm still putting money into stock index funds but looking at the most recent performance, my less than 1% interest savings account is doing better.

    Btw, I'm starting to loath Bernanke and his stated policy of destroying my savings through high inflation and low interest rates.