Monday, October 01, 2007

Personal Savings Rate

The personal savings rate (PSAVERT) is an overall measure of how much individual Americans are saving. It is defined roughly as Disposable Income – Personal Expenditure and expressed as a percentage of the disposable income. Savings is important because without savings there won’t be any investment, and investment in productive capacities, under the direction of a free market, is the best way to make economic progress known to man.

For a long time I was confused about whether 401(k) contributions are included in the PSAVERT or not. I have read opinions on both sides. Finally, I believe I found the answer in A Guide to the National Income and Product Accounts of the United States (NIPA) which defines the Personal Income and Outlay Account. It shows clearly that personal income comprises the usual sources less payroll tax, whereas personal outlay includes income taxes, personal expenditures, interest payments and other minor items. Therefore, 401(k) contributions, including employer matching, go towards the personal savings rate, as I believe they should be.

It should be noted that capital gains are not counted towards personal savings, as they do not appear in the Personal Income column. Nor do I believe capital gains should be counted. The reason is not their capricious nature, as many home owners are finding out, but rather that the only way these gains are to be realized is to be paid from someone else’s savings (in the case of someone taking out a mortgage to buy your appreciated house, he is paying from future savings). We should also note that mortgage payments towards the principle is counted as savings.

Many personal finance writers commented on the PSAVERT when it dipped into negative territory in 2005, so many people are aware of its long term decline from the 1980’s. The chart below is from the St. Louis Fed with recessions shaded in grey.

On a shorter time scale, we can see that the PSAVERT has perked up from its nadir in 2005 (It was very slightly negative in Q3 ‘06), although it’s still at no more than 1%.

Given the collapse of the housing bubble, I expect the personal savings rate to increase. One culprit of the low personal saving in recent years is the consumptions fueled by mortgage equity withdrawal (MEW). MEW is not counted towards personal income but the consumption it enables counts toward personal outlays, hence the housing bubble was directly responsible for the low savings rate. Now that refinancing has dried up, MEW should decrease drastically.

Increased personal savings, whether it’s due to a genuine change in attitude or forced upon by tighter credit, is a good thing. That’s because savings enable investments which develops the economy and lays the foundation for future savings and consumption. Instead, these days all we hear is “Consumption is 70% of the economy, therefore, we should keep consume to get the economy going”. It is repeated ad nauseum and never challenged. As ideas go, it’s got to be one of the most dangerous and damaging ideas ever devised.