Are Surpluses Hurting Savings?

An old theory finds new support

Conventional wisdom suggests that the sharp drop in the U.S. personal-savings rate since the early 1990s has been driven by the so-called wealth effect. That is, soaring household net worth fueled by fast-rising stock and real estate prices has led consumers to cut back saving out of current income.

While he doesn't disagree with this view, economist Ian Morris of HSBC Securities thinks something else has also been at work--a development that has surprising implications for the economy and Federal Reserve policy. That development is the exploding federal surplus.

Morris points out that the U.S. personal-savings rate started to decline sharply well before the huge market surge of the past half-decade. From mid-1992 to early 1994, it fell by 3 1/2 percentage points, while stock prices stayed in the relative doldrums. It was only in 1995 that stocks really took off.

But something else started to happen in 1992, says Morris: The federal deficit as a share of national output began to shrink. And the improvement in the budget since then has been almost a mirror image of the drop in household saving. In effect, rising government saving (or less dis-saving) has been offset by falling personal saving.

This suggests that people's savings behavior is highly responsive to government borrowing--an idea first proposed by David Ricardo in 1817. Ricardo theorized that people realize that rising deficits foreshadow rising future taxes and so postpone their consumption and boost savings to prepare for the taxing times ahead. And they respond to falling deficits and government surpluses by lowering savings.

The U.S. isn't the only country where Ricardo's theory seems applicable. Morris notes that Australia, Britain, Canada, Holland, Italy, New Zealand, Portugal, and Sweden all saw sharp declines in their personal-savings rates in the 1990s. And all also posted improvements in their structural (cyclically adjusted) government budget balances.

At the same time, many have lagged behind the U.S. in wealth gains and economic growth. In the other English-speaking nations, for example, equity markets have been far less buoyant, and sluggish growth hit Canada in 1996 and Britain in 1997 and 1998. Interestingly, Britain's household savings rate has fallen the least (chart)--a fact that may be related to the relatively late improvement in its budget balance.

The validity of Ricardo's theory remains highly controversial. But Morris' point is that it seems to have worked in the 1990s and to be working today. The evidence is not only the examples cited above but also countries such as France, where the structural budget deficit appears to be growing and the savings rate remains high despite surging household wealth and strong growth.

If Morris is right, the Fed may face some hard decisions in coming years. The huge surpluses projected by government economists may never materialize, given politicians' fondness for tax cuts and spending. But if they do, consumption--and the economy--could stay unusually strong as the savings rate falls deep into negative territory.