Neither muppets nor cows
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.