Saturday, November 22, 2008

external effects of propensities to save

There's reasonable concern by people — e.g. Warren Buffett — that low domestic savings rates for long periods of time will ultimately prove unsustainable, and will be corrected by a real depreciation in the dollar. This analysis takes place over a period of time for which money is typically supposed to be neutral; would a highly interconnected region of the United States experiencing a sustained (but unsustainable) low savings rate be expected ultimately to see local prices rise (and wages fall) relative to prices (and wages) nationally? I guess it seems reasonable. I might want to think about more details of the likely nature of such an imbalance.

If Arizona and Florida are, for some reason, less relatively conducive to productive work than to retirement than the rest of the country, you could see a sustainable low savings rate as current wealth flows to those states indefinitely. I suppose prices might end up higher there because of that, but if real wages rose to the same levels as the rest of the country, the comparative advantage in retirement would presumably wane.

The question of "sustainability" is likely more one of the stock of wealth accumulated than of purchase-related flows; in the case I just gave, the sun states are never in debt to the rest of the country. "Wealth", though, is hard to measure; net wealth is a concept related to expected future creation of consumer goods, not past flows (what you might call the "cost basis" of that wealth). In many contexts, especially on a large scale, one might expect one to proxy the other fairly well, but it is a macroeconomic fact that foreign investment from the United States tends to take the form of equity, while foreign investment from many other countries — certainly from Europe to the developing world, and from the rest of the world into the United States — more often takes the form of debt, such that observing changes in net flows of investment income makes the United States look like much less of a debtor nation than you would expect from looking at past trade deficits. (I.e. U.S. investors see a higher rate of return on their past investment than foreigners do.) Little in economics is very backward-looking; the past is relevant insofar as it informs the future. These forward-looking indicators should be more meaningful.

This still doesn't answer my title question, though; what is the impact on me of my neighbors' not saving enough money? I still need to think this one through.

Keynsian multipliers

In a closed economy, savings = investment; if someone has a marginal propensity to consume of 70%, that's a marginal propensity to save of 30%, so if you give them an exogenous windfall, 30% of that feeds back into GDP through investment, giving them that extra 30% in income, which then becomes another 9% of the original sum, so that you get a multiplier of 10/7. Of course, the multiplier effect is hampered by the fact that so much leaks out through the consumption channel instead; as marginal propensity to consume goes up, this only gets worse.

liquidity traps

When interest rates get quite low, the normal basic tool of monetary policy — lowering a targeted interest rate — becomes less effective. At low enough interest rates, simply hoarding any new money put into the system becomes inexpensive; this is the liquidity trap, where the central bank tries to flood the system with more currency and that extra currency heads promptly to mattresses.

Even injecting extra money into the system, once short-term interest rates are zero, requires something other than an interest rate target, but, as Milton Friedman noted and Ben Bernanke quoted, dropping enough money from helicopters ought to eventually trigger inflationary expectations. More fuel efficient and orderly is a process of quantitative easing, or simply a partial monetization of the national debt; these should have similar monetary repercussions. Once inflation is expected, the cost of putting money under a mattress instead of looking to purchase real goods (possibly investment goods) becomes higher.

Part of the problem is that real investments lock up resources for long periods of time; if short-term rates go to zero, leaving normal monetary policy feckless, long-term rates may still be high enough that investors are insufficiently confident that they can produce real returns in excess of the opportunity cost of capital. The mattress may be a less interesting destination for long-term savings than treasury bonds are; monetary authorities would rather neither be as attractive as real investment. Very long term real interest rates should not go negative; one can imagine fantastic projects — an oft-cited example would be to fill in some patch of water with land — that ought, given enough time, to produce returns that exceed the cost. If long-term nominal yields on treasury debt can be pushed down, and inflation expectations can be pushed up, such projects — or more likely ones — should start to attract investors.

One simple way to do this would be for the federal reserve to go about its quantitative easing by purchasing long-dated treasury debt, inflating the currency supply while reducing the relative attractiveness, even in nominal terms, of those modes of saving. The Federal Reserve (in the United States) could do this; alternatively, the same result should come from the Treasury simply shortening the duration of its debt issuances, effectively — relative to its previous policies — selling short term debt (which the fed has pinned to a zero yield) to buy up its own long-term debt. Much of the federal government's recent emergency borrowing for the recent programs to shore up the banking sector has taken the form of bills maturing in the next year, with most of it considerably shorter than that. I wonder, if one looks at the usual impact of monetary policy, whether including the duration of the federal debt, or something like that, adds any predictive value, particularly in times of low interest rates.