Case Study: The Savings Problem

Over the last 20 years household savings rates in many of the rich OECD countries have
fallen sharply. The so-called Anglo-Saxon countries – America, Canada, Britain, Australia
and New Zealand – have the lowest rates of household saving. Americans on average, save
less than 1% of their after-tax income today compared with 7% at the beginning of the 1990s.
In Australia and New Zealand personal saving rates are negative, as people borrow in order to
consume more than they earn.
Other countries with rapidly ageing populations, especially Japan and Italy, have also seen
their personal saving rates plummet, though from a higher level. The Japanese today save 5%
of their household income, compared with 15% in the early 1990s. Only a few of the rich
countries, notably France and Germany, have avoided this pattern of reduced saving.
Germans saved around 11% of their after-tax income in 2004, up slightly from the mid-
1980s.
In the USA the overall trend in saving masks sub-trends in the components of saving.
Evidence suggests that while saving of high-income earners has proved stable, middle-
income saving has collapsed, and low-income earners are increasingly dissaving (Bunting,
2009).
This general trend in the rich countries raises a number of issues:
1 What is the appropriate way to measure a country's savings?
2 Are rich countries saving enough?
3 What kinds of government policy are effective in encouraging saving?
All of these issues involve certain aspects of behavioural economics, although some of the
aspects are not directly related to intertemporal choice. We will focus on those aspects that
are related to intertemporal choice, observing differences between the standard model and its
behavioural alternatives.
The most fundamental point here is that, as far as countries are concerned, it is the total
amount of savings by households, firms and governments that is important.
Thus, saving by firms in the form of retained profit, and budget surpluses by governments,
can in principle make up for any deficit by households. However, there appears to be at least
some interrelationship between these different categories. A theory called 'Ricardian
equivalence' holds that increases in public saving are cancelled out by falls in private saving
as individuals anticipate future tax cuts. An OECD study (de Mello, Kongsrud and Price,
2004) of 16 rich countries between 1970 and 2002 has found that, on average, about half of
any improvement in public finances is offset by lower private saving in the short term, and
about two-thirds in the long term. However, in the USA, one of the most extreme cases of
low national saving, the offset was smallest. This raises policy issues discussed later.
As far as the household saving rate is concerned, this is calculated by subtracting
consumption spending from after-tax income. One measurement problem is that the
definitions of both income and spending that statisticians use in the national accounts do not
bear little resemblance to what people think of as saving and spending. Realized capital gains,
for instance, are not included in income, even though the taxes paid on capital gains are
deducted from income. There is an aspect of mental accounting that is relevant here. People
tend to classify income and wealth into different accounts, and their marginal propensities to
spend and save from these different accounts are also very different. For example, people
tend to have a high MPC with current income, but a much lower one for various categories of
wealth, like capital gains. We shall see that this lack of fungibility has important implications
for government policy.
There are both macro- and microeconomic aspects of this issue, and both have become the
subject of highly controversial debate amongst economists and policy-makers in recent years.
The macroeconomic aspects relate to the function of saving in the economy as a whole, and
in particular its role in funding investment and stimulating growth. We are not so much
concerned with this issue here, although many economists would say that, with a current net
national savings rate of only 2%, the US economy would definitely benefit from a boost in
saving as far as economic growth is concerned. As a result of fiscal stimulus and multiple
bailouts, the budget deficit for 2010 is estimated at 9% of GDP, a historical high. Investment
tends to be low, and the sustainability of overseas borrowing is questionable.
The main issue from a behavioural point of view concerns the microeconomic aspects of
saving: are individuals saving enough? In the last decade, at least four studies have suggested
that people in the USA are not saving enough, while at least three other studies have
suggested that they are saving enough. The reason for the disagreement is that different
studies are based on different assumptions regarding expected earnings, attitudes to saving,
retirement age, desirable levels of consumption during retirement, government policy and
other crucial factors that affect savings adequacy.
In order to address the issue of savings adequacy we must consider the three main motives for
individual saving:

1. Precautionary – people want to insure against a sudden drop in income.

2 Consumption smoothing – people often wish to consume more than their income when
they are both young and old, and therefore save most in their middle age.
3 Bequest motive – people want to leave assets for their children.
Therefore, the issue whether people are setting aside enough from their current income
depends on assumptions regarding what those people will want to consume or bequeath in
future, what wealth they have already accumulated, and what returns on those assets will be.
In the 1990s, many economists argued that in the USA individual saving was insufficient,
notably Bernheim (1993). However, more recent studies have argued the opposite case, for
example Engen, Gale and Uccello (1999) and Scholz, Seshadri and Khitatrakun (2006). The
last of these studies concluded that 80% of US households had accumulated adequate
savings.
However, the main weakness of these more optimistic studies lies in the assumptions made.
First, they include individuals’ equity in their house as part of their financial assets. Again,
the fungibility issue is relevant here. While there is some evidence in both the USA and the
UK that increases in property values have fuelled increased consumption, people still do not
treat such wealth in the same way as other forms of wealth. Not only are such unrealized
paper gains subject to reversal, but there is also an endowment effect here; many old people
are reluctant to sell their house to finance their retirement consumption. If only half an
individual’s house equity is included, the most optimistic study suggests that just under 60%
of US households have adequate savings.
A second important assumption in the studies mentioned is that future state pension benefits
will be paid as promised. Given the budgetary pressures posed by the baby-boomers in many
countries, a reduction in benefits is quite probable, particularly in the USA. For poorer
Americans, any cut in promised pension benefits would significantly reduce the adequacy of
their current saving. Projected payments from social security exceed the value of all other
financial assets for the bottom one-third of the income distribution.
In the UK, where the government’s level of pension provision is set to replace a much smaller
proportion of earnings than in the USA, the situation is similar. A recent report by Britain’s
Pension Commission argued that, given downward trends in occupational pensions provided
by employers and the erosion of state pensions, 60% of workers over 35 are not saving
enough.
A third assumption concerns the rate of return on savings. In recent years, the biggest
difference between high-saving and low-saving OECD countries has been the return on
assets. A recent report from the McKinsey Global Institute (MGI, 2005) observes that
between 1975 and 2003 asset appreciation was responsible for almost 30% of the increases in
the value of household financial assets in the USA, whereas in Japan high saving rates made
up for negative returns on assets. Based on current rates of return and saving patterns in big
industrial economies, the McKinsey study is not optimistic regarding future asset-based
wealth accumulation. There is currently much uncertainty regarding future rates of return on
assets.
Implications for government policy
Some government policies have the effect of reducing saving rather than encouraging it. For
example, in the USA eligibility for welfare assistance such as food stamps is phased out if a
couple has assets over $3,000. In the UK, the means-tested pension credit is designed to help
pensioners, has the perverse result of making saving for workers on low incomes an
unattractive proposition: for every pound of retirement saving a UK worker makes, the
marginal tax rate of at least 40%. However, the new pension system that came into operation
in 2011 should address some issues, by incorporating a default of participation in the scheme,
with a 4% level of income contribution.
One major alternative tax incentive has been to shelter retirement accounts, in effect
subsidizing them. In the USA the subsidy on retirement-saving accounts is 27% of the value,
amounting to 1% of GDP in terms of foregone tax revenue. There is a debate regarding the
effectiveness of this policy, with some economists arguing that it merely displaces saving
from one form to another, without increasing overall saving. However, a study by Venti and
Wise (1989) concluded that “the vast majority of IRA (US individual retirement account)
saving represents new saving, not accompanied by a reduction in other saving.” These results
were confirmed using a different methodology by Feenberg and Skinner (1989).
In summary, there are three main aspects of behavioural economics that have important
policy implications in terms of the adequacy of saving:
 1. Fungibility

Different forms of saving and wealth are not treated as being fungible or substitutable.
This is demonstrated by the evidence from the Venti and Wise study and the Feenberg and
Skinner study. Governments can make use of this lack of fungibility to encourage more
saving.
2. Self-control and commitment

IRAs, like other retirement accounts, are illiquid, since they involve a 10% tax surcharge
if money is withdrawn before the investor reaches 59½ years old. Venti and Wise (1989)
commented that some may regard this illiquidity as an advantage, since it helps ensure
behaviour that otherwise would not obtain. As stated earlier, the general trend in global
financial markets towards greater liquidity may have discouraged saving by removing
such commitment devices. Therefore, governments can encourage more saving by
creating additional commitment devices in the form of illiquid savings accounts with tax
incentives, such as individual savings accounts (ISAs) in the UK.
3. Framing
The desire to save, particularly for retirement, can be much influenced by the way in
which options are communicated to the individual, as noted in Chapter 5. Poorer people,
for example, are more likely to be enrolled in private retirement plans if that is the
employer’s default option than if workers have to elect to opt in. A study by Madrian and
Shea (2001) indicated that shifting to automatic enrollment raised participation among
poorer workers from just over 10% to 80%. UK pension policy has now moved in this
direction. This kind of 'nudge' policy is very much endorsed by Thaler and Sunstein
(2008).

Conceptual Questions
1. Why have different studies come to different conclusions regarding the adequacy of
saving?
2. Explain why putting money in a retirement account might not reduce other forms of
saving.
3. Explain why fungibility is an issue as far as increasing savings are concerned.
4. In what circumstances is illiquidity of assets a desirable characteristic?

Instruction: Use ChatGPT or any other AI tool to summarise the Case, then answer:

1. Identify two important insights, behavioural principles, or empirical observations from the
original Case 8.2 that the AI failed to mention or misrepresented.
Explain why each point is important for understanding the savings problem.

2. Identify one specific statement or interpretation in the AI summary that is misleading,

inaccurate, or overly simplistic in the context of Case 8.2.
For example:
Did the AI imply that people are rational savers based solely on aggregate savings data?
Did it ignore the role of behavioural commitment devices or mental accounting?