A Rise in Savings

By: Andrew Smithers | Thu, Feb 13, 2003
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We are everywhere being bombarded with scare stories about ageing populations being unable to afford to retire. The standard solution is higher savings and, notably in the US and UK where household savings are extremely low, there are plans to encourage more savings.

Even without such help, household savings are likely to rise. They fell with the stock market bubble in the US and are already beginning to rise there. In the UK, they have fallen with the housing bubble and will rise with its demise.

If higher savings meant the end of the problem, we could probably sit back and let it solve itself. Unfortunately, it is far from being so straightforward.

At any one time, the total resources available in the world to pay the pensions of those retired and the wages of those working is constrained by world output. This must be true, whatever has (or has not been) saved in the past. Therefore, either those working must take a smaller slice of the cake than before, or the ratio of those retired to those working will have to remain stable by postponing retirement.

The European approach has been to use taxes, (often called social security contributions), to force those at work to pay for those retired. This approach is breaking down. As the numbers of those retired rise, so do the deductions from wages. As these rise, people became less willing to work or move into the black economy. This pushes up the taxes on those still at work in a vicious circle. Even on the Continent, where a refusal to face economic reality is usually the hallmark of political success, the penny, or euro, seems to have dropped.

With the tax route blocked, higher savings have been seen as the alternative. But this requires income from capital to rise relative to income from labour, which doesn't seem to happen in mature economies.

Happily there are some ways around the problem. First, more people of working age can be encouraged to work. Second, developed countries could export capital to the rest of the world. Third, higher savings could generate higher growth, which would make burdens easier to bear. Fourth, the stock of capital might rise relative to income, so that asset transfers between generations can pay for higher pensions.

The first solution offers the most opportunities. Workers are a tragically low proportion of those of working age in Continental Europe. Not only is unemployment high, but the participation rate is low. Far from easing the barriers to employment by encouraging part-time workers, abolishing minimum wages, maximum hours and employment protection (aka employment prevention) laws, the European Union has seemed determined to make matters worse. They have also been particularly anxious to force Britain to join such follies, lest we should maintain the unfair advantage bequeathed to us by Lady Thatcher.

The export of capital to the less developed world is also beset by problems. Countries either seem to generate all the savings they need, like China, or have dysfunctional governments, like much of Africa.

Large current account surpluses, which are needed for capital exports, also cause political problems. Populations are ageing in markedly different ways within the developed world, partly because of different rates of immigration. The problem is thus much more acute for Japan than Europe and again much less in the US.

In a reasonable world this would mean that (1) Japan would run a much higher current account surplus than it does today, and (2) the US deficit would not be the subject of so much ill-considered concern.

The most promising alternative, therefore, is a rise in the capital stock. This could work because pensions are a form of annuity. Their value does not just derive from the income on the assets, but from the ability to sell those assets to the next generation. If households decide to save more, and the other routes to easing the pension burden remain blocked, this is the way that market forces will be pushing.

But if national savings rise, there will have to be a matching rise in investment. Otherwise the attempt to save more will be thwarted by recession. To get investment to rise, there will have to be more profitable opportunities for it.

This could be done by cutting taxes on profits, but even in the US this is not the top political choice. Here in the UK we have gone in the opposite direction. When Gordon Brown abolished ACT he effectively raised UK corporate tax by 50%, which is probably why the UK missed out on the investment boom of recent years.

It would be encouraging if the Chancellor repented, but the bookies would probably give high odds against this. Higher UK savings could reverse our large and growing trade deficit. This would, however, simply shift the problem to others.

Labour reform in Europe, sound government in Africa and lower corporate taxes everywhere, are the solutions to the pension problem. Sadly, this is not quite as bad as trying to put pigs on the wing, but it's not far off.


Andrew Smithers

Author: Andrew Smithers

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

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