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Neither muppets nor cows

2013/08/14

After some people read my latest article on CARTA in German language about savers, interest rates and inflation , there were some lively discussions, and maybe a little confusion, on Twitter, and in what follows I would like to briefly clarify my view.

When Mark Carney, the new Governor of the Bank of England (BOE), announced that the Bank would not raise its base rate until unemployment is below a 7% threshold, savers were outraged. They accused the Bank to “steal” their money as interest rates are below the current rate of inflation.

In a blog post Frances Coppola defended the BOE decision against the “unreasonable expectations of savers”, and in my CARTA article I summarize the various scenarios she described arguing that savers “have no right whatsoever to expect to receive a higher rate of return than the ability of the economy to generate that return”, whereby return is defined as the real rate of economic growth.

In my view, the merit of Frances Coppola’s article is that it is drawing the attention to the fact that in an economy nothing can be spent that is not earned. Several authors took up the idea. Two examples, an article by Tomas Hirst on Pieria on “The symbolic importance of not raising rates”, and another by Dizzynomics on “Savers are not sacred cows, redux”, may give you an impression of the reasoning.

I don’t want to go into detail here. Instead, I want to ask why savers are getting interest at all and who is paying the rising prices in an inflationary economy.

Textbooks tell us that the interest rate is the price of money which – as every price in a market economy – is determined by demand and supply. The interest rate is the compensation for savers’ decision to defer consumption into the future (an argument Frances dismisses as “utterly bonkers”). The rate can be thought to consist of three components:

- One is a decent return allowing the saver to participate in the economic growth to which his savings contribute, as money is considered not to be left idle in a bank account but “working” and earning a return in one way or the other.

- Another component is compensation for an expected rise of prices. This is the point which is debated. But savers may prefer to spend their money now if they expect getting less for it in the future.

-  The last component is compensation for risk. For savers holding money in a bank account this may be negligible (although recent developments clearly demonstrated that there is no such thing as a riskless investment).

Note that risk and inflation are two different aspects. If assets are risk-free, savers would still want compensation for rising prices. Without inflation they would still consider the risk involved in putting their money in a particular bank and demand compensation for it.

The aforementioned authors stress the risklessness of savings as an argument to deny savers the right of interest compensation. To quote Dizzynomics:

“Savers who have not invested in productive capital assets (at risk) but who are keeping money in the bank simply cannot expect interest compensation without taking principal risk.”

Or, Frances Coppola:

“The desire of savers to be compensated for loss of purchasing power is understandable but wrong. The risk-free rate of return is related to the growth rate of the economy, not the inflation rate.”

As I see it, the flaw of this argument is to mix up the risk and inflation aspects of savings decisions. As a consequence, the crucial question is left aside, namely: Who benefits from, and who pays for, inflation?

Assume, for a moment, that price rises are evenly spread over all sectors of the economy. Then producers and sellers of goods earn their share of real economic growth – and more than that: They also gain from inflation as their prices are nominal prices containing a compensation for the inflation rate. On the other hand, they also pay for inflation as the prices of materials and services and other intermediaries they buy are nominal prices, too.

At this point, we have to ask: Why should the price of money, which also is a sort of intermediary provided by savers to keep the economy going, be singled out reflecting only the real growth rate, thereby denying its owners the opportunity to participate in economic success in the same way as others?

Don’t get me wrong. I do not proclaim to accept rising prices wherever they manifest. But treating one group differently is no solution. The result is a hidden redistribution of incomes from savers (and workers and consumers) to debtors (and producers and sellers) which is no effective instrument to fight inflation.

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5 Comments
  1. Agreed. Also Governments who don’t set up generous savings schemes, for example, for risk averse tax resident pensioners will lose an increasing portion of their voters. The last thing that entrepreneurs who have taken lots of risks in their working lives and been lucky enough to accumulate some capital want to do in retirement is to worry about taking risks to cover inflation.

  2. Thank you for your comment. In principle, the same arguments holds for young entrepreneurs who may not like older-age prospects. All in all, it may be a serious locational disadvantage.

  3. Rafael permalink

    “As I indicated in my last sentence, I consider savers and workers (and consumers) on the same side in that they lose if prices rise. ”

    I think you mean this, but I want to explicitly state the following.

    -If prices rise and wages do not at least change at the same rate, wage earners are worse off due to inflation.

    -If prices rise and the rate of return on financial assets and/or interest on deposits do not compensate for the change, savers (holders of financial securities and/or deposits) are worse off.

    -Therefore if the above two conditions hold, the sellers (owners) of the goods or services whose prices are rising equal to or great than the rate of inflation, will be better off.

    -Given the balance of the three conditions, it is possible for prices to rise and savers to be made better off as long as the change in the nominal rate of interest (rate of return) is greater than the change in the rate of inflation. Same goes for wage earners. If wages rise by greater than the rate of inflation they are made better off.

    “If this is the case in an overheating economy policy might want consumers to buy less and in this situation, an increasing demand by savers (or rising wages) would not be welcome either. ”

    Agreed. This is described in the my first post in the final scenario (too high economic activity is resulting in high inflation)

    “In my view, this is not so different in an ailing economy where inflation is caused by external influences. If firms shun investments they will meet an additional demand by additional price increases.”

    Yes, and as long as the rate of interest (rate of return) and wages fail to compensate, the higher prices result in great profits for the firm. If the firms do not face any competition, they might find it beneficial to keep prices elevated or rising until profits begin to decline. If firms face competition and both the rate of interest and wages are not compensating where incumbent firms are gaining by increased profits, than new firms should be signaled to enter and compete. This in itself should push incumbent firms to either lower prices, investment spend, or see their new competitors take advantage of low relative wages and rates of interest (cost of capital) to compete. Once the new firm has won market share, there should be potentially more competition for workers, lower prices, and/or higher rates of return to attract savers/investors.

    Therefore, in an uncompetitive environment where incumbent firms use strategies to increase profits, savers and wage earners both may lose.

  4. Rafael permalink

    Also I wanted to briefly define saving.

    Saving is the desire to accumulate deposits and/or other financial securities. The act of being paid interest in the form of deposits on accumulated deposits and/or financial securities is an act of financial accumulation.

    Working for an income paid in deposits, allows for the possibility of accumulation. Holding on to financial securities that pay interest, such as deposits when they do, allows for accumulation.

    If incomes are declining and/or not rising to the point where wage earners are compensated for inflation (falling real incomes), than it would not be fair to supply savers with interest rates that protect them against inflation. Again, low real rates could be a signal to savers that the system needs them to stop accumulating and start recycling those deposits (either by consumption or investment spending on labor). This recycling is needed in order to stop income decline or stagnation.

  5. Thank you for this interesting comment (although I don’t agree). As I indicated in my last sentence, I consider savers and workers (and consumers) on the same side in that they lose if prices rise. If this is the case in an overheating economy policy might want consumers to buy less and in this situation, an increasing demand by savers (or rising wages) would not be welcome either. In my view, this is not so different in an ailing economy where inflation is caused by external influences. If firms shun investments they will meet an additional demand by additional price increases. In all these cases, the solution is to contain inflation at the source and build confidence (why should savers invest if firms which know better don’t?), not to put an extra burden on individual groups in society.

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