Do Savers Need to be Saved?

The Bank of England is following the Federal Reserve and the ECB in adopting forward guidance. Bank of England Governor Mark Carney announced that the Bank will not raise interest rates until the jobless rate--currently 7.8%-- falls to 7% or below. According to the Monetary Policy Committee (MPC), this state-contingent forward guidance implies that interest rates are likely to remain at the current 0.5% rate for about three years.

The backlash against this announcement of continued low rates is particularly strong and vocal in the UK, where an organization called Save our Savers is campaigning against "artificially low interest rates." The organization writes, "Although the financial crisis was caused by debt, the Bank’s policy continues to favour borrowing at the expense of saving." This sentiment appears, sometimes in more subtle forms, in the US too. Perhaps the most notable counterpoint to Save our Savers is Frances Coppola, who has this to say about low interest rates and savers:

"The desire of savers to be compensated for loss of purchasing power is understandable but wrong...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... 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."

Note that the result that Coppola alludes to about the risk-free interest rate equaling the growth rate applies either to nominal interest rates and nominal growth rates, or to real interest rates and real growth rates. The UK actually has a 0.6% real growth rate, and 0.5% nominal interest rate. The nominal growth rate is over 3%. Also note that this is an equilibrium result--it holds when the economy is in "steady state," i.e. not always and not now. The UK nominal interest rate is several percentage points lower than the nominal growth rate. This has savers up in arms, and that's kind of the point. In theory, some of the savers who dislike earning the ultra-low risk-free rate could shift some of their consumption from the future to the present. That would raise current consumption relative to future consumption, reducing the growth rate of consumption, bringing the economy nearer to equilibrium. That is part of the goal of low interest rate policy. But it depends on how willing people are to substitute consumption "intertemporally," and how much utility they lose by doing so. To explain:

Interest rates theoretically have two opposing effects on savings decisions. On one hand, a higher real interest rate makes future consumption cheaper relative to current consumption, leading people to save more-- the substitution effect. On the other hand, a higher real interest rate increases the return on saving, giving some consumers more lifetime income--the income effect. The combination of the income and substitution effects means that the effect of higher real interest rates on consumption is theoretically ambiguous (see this survey or Chapter 7 of David Romer's Macroeconomics). An important parameter in models of consumption is the intertemporal elasticity of substitution, which tells us which effect dominates.

Savers who have low intertemporal elasticity of substitution are not very willing or able to shift their consumption forward in time to benefit from the fact that current consumption has been made cheaper relative to future consumption. Thus they have special reason to hate low interest rates because they amount to lower income. The most commonly cited example of this type of saver is a person who is retired or nearly retired:

"Obviously, for retirees who are living in part on investment income, low rates have an immediate impact on their standard of living. With few prospects to add to whatever they've managed to set aside in their retirement nest eggs, retirees are largely at the mercy of banks and other financial providers that determine how much interest they're willing to pay their customers on their investment balances."

Hearing about these retirees is particularly compelling and makes it seem like low interest rates are violating an implicit social contract. Coppola says that "savers have unreasonable expectations." Is it unreasonable for for people who have worked and saved for years to expect a decent standard of living in retirement? Well no, it is not unreasonable, but higher interest rates are not the way to meet that expectation. Decent standards of living for retirees should be part of the social contract, but should be promoted through programs that target retirement security and/or consumer protection directly, and not through interest rate policy. (Just as financial stability should be promoted directly through regulatory policy, not through interest rate policy.)

Plus, not all savers are in the same boat as these retirees. For some people, the substitution effect dominates. Higher interest rates would encourage the more intertemporally elastic folks to spend less today, which would have majorly bad implications. Being unemployed hurts your income even more than getting a low return on your savings does.

A question on the the European Commission Consumer Survey asks consumers whether this is a good time to save, and a "good time to save" index is constructed by computing a balance statistic from the positive and negative responses. Here's a graph of the UK discount rate (downloaded from FRED) compared to the UK "good time to save" index. The correlation coefficient is 0.70.

Constructed by Binder with data from FRED (INTDSRGBM193N) and EC Consumer Survey (Q10 Balance Statistic)

The general tendency is that when interest rates are higher, people think it's a good time to save. But we don't know exactly what people mean when they say it is a good time to save; people can think it's a good time to save for multiple reasons. Most straightforward, high interest rates mean a higher return to saving. You might say it's a good time to save if you have a lot more income than you want to spend-- in good times, save some of the excess. In this case you would think it was both a good time to save and a good time to spend. But you might say it's a good time to save if you are trying to deleverage, or if your net worth has fallen and you are trying to build wealth back up to some target level, or if you fear losing a job soon. In these cases you would think it was a good time to save and a bad time to spend.

To get a clearer picture, it is useful to plot the "good time to save" index along with the "good time to spend" index, also from the EC Consumer Survey. Before 2008, the two indices had a mildly negative correlation coefficient of -0.34. Very roughly speaking, in bad times people favored saving and in good times they favored spending. But now? After 2008, the correlation coefficient is 0.40. Now it's so bad that both indices are low. It's a bad time to be a saver, and it's also a bad time to be a spender. People don't have extra money to save or to spend, and until the labor market improves, they won't. Raising the interest rates cannot possibly be helpful in this situation.

Constructed by Binder with EC Consumer Survey data