The Return of American Savings...

This is something that I almost never see addressed in the media or practically anywhere else. And its a phenomena that bears mentioning, because it has tremendous implications for nearly every aspect of economic policy. I'm talking about the return of private savings in the United States. Take a look at the graph below; private saving as a share of gross domestic income is at a historic high since the late 1970s.

If this rate stays high, it will have tremendous benefits for the economy in the coming years.
1. Interest rates will remain low, regardless of international capital flows. This will keep interest costs on the Federal debt low as Medicare and SS costs continue to rise and alleviate pressure to raise taxes and run higher deficits.
2. Global imbalances will subside as domestic investment is funded out of domestic savings. This means a re-balancing of East Asian economies and even more net-factor payments to bolster American GNP.
3. Improved household net worth will take pressure off government social programs that make up 2/3 of Federal outlays. If individuals start accumulating savings at a faster clip, programs such as SS, Medicare, Pell Grants, ect. all become less critical for the median American, as retirement income, health spending, and college can be funded on an individual basis drawn on a private stock of savings.

Bernanke Is Not to Blame for Low Rates #387

Thought I'd hammer away at this again because I hadn't in a while. But it bears repeating because of the enormous policy implications and the political lobbying power of people who don't like low rates. Anyways, with the knowledge that "the" real interest rate will adjust and remain at an equilibrium that balances savings and investment in an economy, we expect the interest rate to fall when saving increases relative to investment. Bear in mind, this is the natural operation of a secular market, with no policy interference; simply a price changing to clear a market. Well check out the graph:

Ben Bernanke needs to throw this graph right in Paul Ryan's face next time he starts complaining about the "financial repression" caused by "artificially" low rates. Serisouly, look at that: in 2010, the American economy funded ALL the private investment firms wanted to make out of domestic savings and had over a trillion dollars left over. Of course, that was more than absorbed by the Federal budget deficit, which is why we still ran a current account deficit. But with inflation expections running so low and the private sector flooding the economy with net savings, low rates are the result of the market system, not an act of policy or choice.

P.S. as luck would have it David Glasner just made a new post with exactly this theme, but of course a lot better. Here's an exerpt and a link:
"First, it can’t be emphasized too strongly that low real interest rates are not caused by Fed “intervention” in the market. The Fed can buy up all the Treasuries it wants to, but doing so could not force down interest rates if those low interest rates were inconsistent with expected rates of return on investment and the marginal rate of time preference of households."

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

The Borne-Out Identity: Savings and Investment

One of the most well-known and oft troted out identities in economics is the identity that says savings = investment. This identity can be derived in a simple manner as J.M. Keynes did in the second chapter of the General Theory:

Income = Consumption + Investment 

Savings = Income - Consumption 

Therefore Savings = Investment

For fun, I ran gross private savings in the US against gross private investment. 

Notice that at times private savings exceeds investment, and other times vice-versa. This is because there are other types of saving and investment other than "private." Government budget surpluses are public savings and deficits are public dissavings, while foreign capital inflows (or outflows) allow for private investment to exceed (or under-exceed) private savings. 

By looking at discerepencies between these two lines, we can see patterns in these trends for the US; notice how private savings exceeds investment in in the early 90's but falls below at the end of the 90's, when the budget surplus added public savings. 

IS-LM and the Price Level

One criticism that is sometimes made about the IS-LM model is that it neglects the price level. The determinates of the model are the real interest rate and GDP; but the price level IS present in the framework. In the LM function that represents the necessary levels of (r) and (Y) that clear the market for real money balances, the supply function in the market is the real, as opposed to the nominal, money supply.

What this means is that a change in the price level, that is to say deflation or inflation, will shift LM either up or down. The real money supply is defined as M/P, where M is the nominal money supply and P the price level. A fall in P, that is to say deflation, leads to a smaller denominator and hence a larger real money supply. Inflation, that is to say a rise in P, leads to a larger denominator and hence a smaller real money supply. Recall that an increase in the real money supply relative to money demand causes the LM curve to shift to the right; a decrease causes a leftward shift.

This mechanism, where changes in the price level change the real money supply and hence the position of the LM curve, is the mechanism that theoretically allows the LM to reach FE equilibrium without a change in the nominal money supply, that is to say monetary policy. If the IS-LM intersection is left of IS-FE (the interest rate compatible with full employment), a then there will be downward pressure on prices: workers will accept lower nominal wages, and firms will cut nominal prices to move pilled-up inventory. This decrease in P then causes M/P to expand and shift the LM curve to the right until FE is reached. If IS-LM is to the right of IS-FE, then nominal wages and prices will rise (i.e. inflation) and M/P will contract until LM is once again at FE. So the price level does factor into our IS-LM analysis; its just hidden in the LM curve.

But what are the implications for Eurozone policy?

Combining the Models: IS-LM

So now we have two seemingly unrelated markets that are both cleared by the same thing: the interest rate. The IS-LM model, developed by John Hicks in 1936, combines the two. The model relates the interest rate (r) to GDP (or income on a national level) (Y). The two functions are not supply and demand but a downward sloping function representing cominbations of Investment and Saving corresponding to each combination of (Y) and (r). It's downward sloping because as income increases, saving increases relative to investment leading to a lower interest rate. The upward-sloping function is the Liquidity-preference and Money supply function which is upward sloping with relation to income because as income grows, money-demand increases due to the fact that more money is required to carry out more transactions in a larger economy; this causes money demand to grow relative to money supply, causing rates to rise. Yes, this is potentially the most obtuse collection of concepts in macroeconomics and the most convuluted framework ever. It makes more sense to see it put together piece by piece, but I don't have the ability to make the graphs I need myself and Google has failed me yet again.

As you can see, IS and LM intersect at FE, or the Full Employment level of GDP. This graph represents an economy in equilbrium, where the central bank has set the money supply relative to money demand in such a way as to set the LM curve along the IS curve so as to reach full employment and stable prices. If the central bank were to contract the money supply, the LM curve would shift to the left along IS, resulting in a new Y below Y*; in other words, a recession. If the central bank expanded the money supply relative to money demand, LM would move to the right of the current IS-FE point; that would mean an equilibrium point on Y above the FE level, which is to say an inflationary gap.

This brings us to the price-level aspect of IS-LM, and then onto its implicaitons for Eurozone policy. I can hardly wait.

Why Monetary Policy Matters Anyway (part 1): Loanable Funds

As I've demonstrated earlier, I'm a euroskeptic (I didn't invent the term) primarily because of what I see as the disasterous experience of the ECB: the periphery countries of Europe have been saddled with a monetary policy that has been tailor-made for Germany and Germany alone; the result has been stable prices and full employment for Germany; unemployment and depressed incomes for Italy, Spain, Ireland, and others. Now I want to delve into why that is: why does the monetary policy of the ECB have an effect on the economic performance of European economies at all?

Monetary policy affects the economy by affecting interest rates: monetary easing lowers rates, while tightening raises them. Lower interest rates entice firms to borrow for investment projects and encourgae households to save less. Higher interest rates discourage borrowing for investment and encourage household saving. The market for loanable funds thus determines what the equilibrum rate of interest will be for the economy: the the graph below, savings is the upward-sloping function of the interest rate (r) and investment is the downward sloping function. This is known as the loanable-funds model.

The savings function is an upward-sloping function of the real interest rate because households want to save more when the reward for doing so it higher. The amount of saving, however, is determined by both the interest rate (r) AND the level of income (Y) so that we write S= f(r, Y). Investment is a downward sloping function of the real interest because more investment takes place when borrowing to do so is cheaper. Since S=I in equilbrium, holding (Y) constant, (r) adjusts until the quantity saved = quantity invested; the market for loanable funds clears like any other.