Sunday, January 16, 2005

Don't be duped - American consumers act rationally

Expert View:
By Mark Tinker, The Independent

16 January 2005

January is when pundits are expected to make predictions. For the past few years the entertainment has been provided by a new twist of doom and gloom on what is essentially the same prediction: the imminent collapse of the US consumer.

We are told this year that spendthrift Americans need to save more and spend less. But can it really be the case that the US - the wealthiest country in history, with the largest and most sophisticated financial markets in the world, a giant mutual fund industry and pension funds with assets running into trillions of dollars - is not saving for the future? No, of course it isn't.

So how has this misconception arisen? Mainly through the misuse of a statistic called the "savings ratio", which in the US is close to zero. This relationship measures income not consumed in a given quarter - a cash-flow measure. It bears no relation to what we understand as saving. By contrast, Federal Reserve "flow of funds data" shows a net addition to "financial assets" (savings, to you and me) of $870bn (£466bn) last year.

The problem with the so-called savings ratio is that it looks at the cash flow, not the balance sheet. The American household has seen the value of its equity assets rise sharply over the past 18 months and rationally decided that, since its existing stock of assets had earned a return, there was no need to top it up with much more cash. In effect, its pension fund was fully funded.

We save for three reasons: deferred consumption, precaution and speculation. For there to be "enough" saving, it has to meet the precautionary and deferred consumption needs of the household (pay a pension), and nationally there has to be enough saving to provide capital for investment. Currently in the US there is more than enough cash to meet investment needs; it's just that there haven't been any needs for a while. Importantly, most new investment comes from retained company earnings, which have been incredibly strong. This cash shows up as corporate income and on the corporate balance sheet, but of course it is really on the balance sheets of households since they own the corporates through their equity holdings.

Owning your own home is also a key part of the deferred consumption equation; if you don't, you will have to own another asset that will enable you to rent one. Over the past three years, Americans have been selling equities and bonds and buying houses. The ensuing debt and rise in house prices is regarded by the perma bears as an irrational bubble, but to a man with a hammer, everything looks like a nail.

Here's the final twist. Unlike the US, other G7 households are a long way from meeting their pension requirements, which is why they aren't spending. They need fixed income and housing. In the UK they are buying housing, and getting squeezed by our absurd floating-rate mortgages. The Japanese, faced with domestic bonds yielding just 1 per cent, are buying US government bonds which yield four times as much, and the Europeans are buying up higher-yielding corporate bonds, municipal bonds and mortgage bonds.

Thus there is a forced saving in most of the G7, which is chasing yields in the US. This translates into a capital account surplus, and by definition an equal and opposite current account deficit. It means that, far from being the over-leveraged, irresponsible spendthrift of popular (and populist) imagination, the US household is in fact entirely rational in its behaviour. Moreover, far from depending on the rest of the world to fund its spending, the rest of the world are relying on the US for their savings and, in many cases, their jobs.