The Big Money: Banking Your Money Hurts the Economy

A good three years before the current financial crisis, some of the smartest thinkers on the economy—people like NYU economist Nouriel Roubini, Morgan Stanley's Stephen Roach, and billionaire and all-around economic oracle Warren Buffett—started pointing out to everyone who would listen that things were going very wrong. There were three major things that worried them: the unprecedented housing bubble, the fragility of ever-more-complex Wall Street relationships, and the savings crisis. In 2007, the housing bubble decompressed. In 2008, Wall Street unraveled.

Now it's 2009, and the last punch is coming into view: The scary economic story of the next year is likely to be the painful unwinding of the great savings shortage. Thanks to the catastrophic savings deficit of the last decade, we now have on our hands a spending and credit crisis that will make our recession much harder to solve.

Today's Wall Street Journal and others have pointed out that the U.S. savings rate, which for most of the decade was as low as had ever been seen in a major post-World War II economy, is finally going up. In just about any other time, this would be very good news. But right now it's not. Our savings are finally rising but not because the United States has suddenly become a thrifty nation. It's happening because after years of spending everything we earned, there is suddenly no money available for consumers to borrow and no money safely stored away for us to fall back on.

Remember the story of Joseph and the pharaoh? In our contemporary version, the pharaoh went to Joseph with his dream of the seven fat cows and seven thin cows, and the response he got from Joseph (well, Alan Greenspan, really) was, "Don't worry about it. If things get rough you can just tap into all the equity you've got in the Pyramids. Saving doesn't really matter." It turns out it does.

I've always hated reading articles about savings; they inevitably make you feel like you have been kept after school to write the same old truisms on the blackboard 100 times. Some writers—Warren Buffett comes to mind—have managed to write entertainingly about the virtues of savings, but they are rare. Stories about savings rarely feel like they have much urgency: They tend to make a point that we already heard yesterday about something we should do next week.

But there's more worth knowing about savings than you might imagine. Over the last weeks, you've heard a lot about spending, with each month bringing a new stimulus plan designed to pump money into the economy. In a recession, consumers have less money. The less money they have, the less they spend, the more the economy contracts, and the worse the recession gets. The idea of an economic stimulus is to make people spend more money to counteract this worsening cycle. It's why the Bush administration has doled out some $350 billion to banks to lend and why the incoming Obama team is talking about a crash program of emergency tax cuts.

All this money, however, is like a flock of pigeons released directly into a gale force headwind. They try to fly, but it's awfully hard not to get blown right back. Because even as the government tries to get consumers to spend more, there's a powerful force making them spend less—a force we haven't had to contend with in other recessions. To understand this force and just how powerful it is, you need to understand the savings deficit and its repercussions.

Through most of the postwar years, Americans saved roughly 9 percent to 10 percent of their incomes. During the last two decades, that number steadily went down, until sometime around 2005—the exact point depends a bit on how you measure savings—when the U.S. personal savings rate hit zero, another way of saying that Americans spent pretty much every cent they earned. The moment was a two-day story in the papers, which generally noted that this was the only time in 20th-century history that an industrial country had negative savings in a period of economic growth and the first time the U.S. savings rate had hit zero since the depths of the Depression.

It takes but a moment of thinking to see why savings rates would have hit bottom in the Depression: In times of economic trouble, people take money out of their savings instead of putting it in. We all get that. Savings are a financial cushion, and having savings that can be withdrawn and turned into spending gives us a natural "stimulus package" that evens out the economic cycle.

With this in mind, you can start to see just how extraordinary the zero savings rate of the last few years was. Because if American consumers saved nothing when the economy was good, what are we to do when the economy is bad? Spend even more? When we start with a savings rate of zero, finding a way to keep up consumer spending is much, much harder. In this sense, our situation is actually worse than that of Japan in the '90s, when it suffered an extended period of slow growth and economic stagnation. Japan's savings rate then was generally in the range of 10 percent or more. The Japanese had plenty of room to cut their savings and spend more, and as they did, the economy picked up (Japan's savings rate is now a quite low 2 percent). Japanese consumers had the option of saving less and spending more. We don't.

There's nothing in economic theory that prevents the savings rate from going below zero—but in practice (i.e., real life) this isn't what's happening in the United States. Right now banks aren't interested in lending more money but instead are desperately trying to limit their exposure. Home equity loans have essentially disappeared, going from some $700 billion a year to close to zero. And despite the government's efforts—from interest rate changes to boardroom arm-twisting—to get banks to lend more money, the big lenders are understandably reluctant to risk making the same mistakes next year as they made last year. While the rate the government charges banks to borrow money has fallen to almost nothing, the rates that card issuers are offering new borrowers have barely budged, and the limits for many current borrowers have fallen (that last bit, by the way, I've seen play out with my own credit cards). If, as is widely expected, consumer lenders get hit with a wave of defaults next in their portfolios, they will almost certainly become even more cautious about lending money, and the situation will get worse.

Which brings us back to the savings rate. You've already seen that in normal recessions, the savings rate goes down and cushions the blow to consumer spending. But now we are in the midst of a strange kind of backward recession. As lenders retrench, instead of the savings rate going down it is, in fact, going up. This is what economists call "de-leveraging": In economic terms our "savings" go up because our borrowing goes down. This isn't savings as you normally think of it. It's an enforced regime of austerity thrust upon us because having relied on debt for so many years, we have no way to keep funding consumption.

Just how much the lenders will retrench is, if not exactly anybody's guess, an opaque and technical subject. Nouriel Roubini thinks that the fall in lending—that enforced savings—can cut consumer spending by 4 percent this year and 8 percent next year: a total of $1.2 trillion, more than enough to swallow up all the tax cuts and stimulus checks that the government is trying to throw at the problem. Hopefully the number will be lower. We just have no good way of knowing.

What we do know is that the savings crisis that policymakers and economists ignored in the middle of the decade threatens to clobber the economy next year. What looked like a long-term problem of how we will find the future of American retirement has turned into a pressing, immediate problem of how we can raise the money to get out of the jam we're in. We have a recession on our hands, worse than anything we've seen since at least the '50s, and suddenly the usual response to recessions—lowering our savings—just isn't an option. We all know that having savings is a good thing for some indefinite time in the future. But even the people who warned us about the savings crisis didn't think that future would arrive this soon.