28 August 2009

Interest Rates and Savings

A naiive assumption which policy makers, reporters and opinion makers frequently rely upon as if it were true is that low interest rates discourage savings and encourage debt, while high interest rates encourage savigns and discourage debt. This is simply microeconomic thinking in practice.

The trouble is that reality isn't aways so convenient. Savings rates in the U.S. are the highest that they have been in a decade, despite the fact that a savings account at my local bank produces a meager 0.3% per annum rate of return, before taxes and without any adjustment for inflation. Aggregate consumer debt levels, meanwhile, are falling, something that we haven't seen for a long time, despite the fact that interest rates on car loans, mortgages and credit cards are below historical averages and not too far from record lows.

The lack of an interest rate spike is particularly odd given that default rates on consumer loans are at record highs. Financial Economics 101 tell us interest rates can be decomposed into a "risk free rate of return" in the credit markets (operationally determined by the market for Treasuries) and a "risk premium." Yet, despite the fact that consumer lending is empirically riskier than it has ever been, the risk premium hasn't shot up by anything close to the levels that current high default rates would imply lenders need to offer to make money.

Part of the issue is that lenders have responded to the financial crisis by tightening their underwriting standards (i.e. how easy it is to get a loan in the first place) rather than by increasing interest rates.

Like most weird phenomena in real world economics, there is also an element of "price discrimination," i.e. charging different people different prices for the same thing. Banks have targeted their riskier, credit dependent customers for higher effective interest rates in a way that doesn't have to be disclosed as a higher interest rate when people apply for credit cards, by piling on fees for the kind of conduct that high risk customers tend to engage in (like exceeding credit limits and making late payments) and quickly pulling the trigger for default interest rates that are much higher than the interest rates paid by those who make every payment as agreed.

The last big explanation of what we are seeing is the often useful lifetime income hypothesis. Empirically, a lot of the consumer debt bing we saw over the last decade was a function of people spending increases in the value of their homes and investments, even though they hadn't sold those assets. They felt wealthier and borrowed (implicitly or actually) against their investment gains in these assets.

When the asset price bubble (both in real estate and in financial assets) collapsed, people who used to feel like their asset prices had afforded them an ability to engage in consumer spending and relieved them from having to save, have now found themselves with much more debt relative to their assets (a huge percentage of homeowners with mortgages are now under water or very nearly so) and direly needing to save money for their expected future wants. Their expeected lifetime income has fallen and they are readjusting their lives accordingly.

So, is this some shockingly new phenomena? Not really. Baby Doe Tabor, a Colorado history heroine, experienced almost the same thing starting back when the United States currency was partially tied to the price of silver. It wasn't called the lifetime income hypothesis back then, but this not particularly new economic theory does explain how people acted, even back then.

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