Friday, 18 October 2013

Savings, Inflation and Social Security: Why Savers Shouldn't Complain

Although I may be a bit too late to join the discussion of whether savers should be saved from rising prices I will add my two cents to it. The whole idea started when Frances Coppola published her first article on the subject arguing that savers should not be compensated for any loss as a result of increased inflation with John Aziz noting that if savers wish for higher returns they should not invest in cash. In response, Save our Savers basically commented that savings are important and they are a driver of investment which promoted another response by Frances Coppola on how savings and investment actually work in an economy. Although this may not come as a surprise I actually agree with Frances on the subject and I will try to put it as simply as possible, using a paper by Paul Samuelson in assistance.

Imagine an economy where people tend to have two possible states: they are either producing or they are in retirement. Of course, there are those who are not producing and are not in retirement, such as children but we can account for them in the consumption of the workers (in the sense that retired people usually do not have to support children while other adults usually do). When people retire they cannot produce any more (which is more or less true in real life as well). Another assumption here is that goods cannot be stored with ease; basically the young cannot store goods for their retirement. This becomes more easily understood if we think of it this way: we cannot store apples or meat in our 30's or 40's to consume in our 60's and 70's. The same would hold for almost any other good which can be consumed.

In the absence of money in this economy, the old would starve to death as soon as they reached their retirement. The reason is simply that young ones have no incentive to decrease their consumption and give some to the old as they cannot know that the future young will do the same. In fact, they already know that the future young will not do the same. In this society, the old have nothing to hope as soon as they reach retirement.

There are only two ways that such a situation can be remedied: if we introduce some sort of legislation forcing the young to give to the old or if we introduce money as a store of value. Let's start off with the latter. Here, money has the basic purposes of serving as a store of value and a medium of exchange, having no consumption value on its own. By introducing currency in the economy we are making the elderly much better off: we are allowing them to save when they are young and have some wealth to consume when they are old. In the absence of a good which can be stored, consumption cannot be postponed. As we introduce money, people can, and is to their best interests to, postpone current consumption for consumption in the future if they do not wish to die of starvation when they reach retirement age.

This situation appears to be quite similar to the one we face now: savers have been saving through their working lives and are now using their savings to consume. Yet, in this model, the big bad wolf is inflation: in this simplistic economy, prices can be shown to rise at the rate of population growth which can be shown to be higher than the interest rate, if no other variables affect the rate (see the Samuelson paper for details). In real life, inflation is in many cases higher than the rates paid by the banks for many other reasons, in addition to population growth. This means that the value of savings is reduced (or increased) each year by the difference between the interest earned and inflation rate.

Thus far I do not believe that anyone would disagree with the analysis. This is where things get interesting: as the reader may recall, we have specified two actions which can make the situation better for the retiree: one was the introduction of money and the other was legislation. This legislation, in the absence of money in the economy, would force the workers to hand over some of their consumption to the old so that they would not die when they reached retirement. This is basically what we call the pay-as-you-go system which is dominant in state-funded pension systems. Basically what is done is that the state takes from the workers and gives to the retirees based on what the retirees had given when they were themselves workers. This, solves the problem of providing for the retirees in the absence of money.

Remember this though: in our world, both a unit of currency to store and exchange and a social security system exists. Thus, we are in fact using the best of two worlds, combined: we give our workers both the opportunity to save when they are producing and we also provide them with added benefits of pensions (i.e. consumption moved from the young to the old) when they retire. Thus, not only are they not losing money when prices are rising but they are in fact gaining: they have had the opportunity to save and enjoy their wealth later but they lose something which is probably 1-2% per year on their savings. Yet, most of the times (and the exceptions are those with extraordinarily high savings), pensions are more than compensating for that loss. Not only are they compensating for that but most pensions are usually inflation-adjusted at some point which makes retirees earn even more, not to mention what happens when the difference between interest and inflation is positive.

A numerical example should shed more light: a retiree has 100,000 units of currency in the bank earning 0% of interest, while the inflation rate is 3% per annum, at a loss of 3,000 units of purchasing power per year. Although in this case the bank rate would almost certainly be higher we can show that even in this extreme case the saver is earning. If the saver earns 12,000 units of currency as his pension each year, the loss of 3,000 is more than made up for. The retiree would have to earn less than 250 units of currency as his pension each year to face losses, even from such an extreme scenario.

One question which might spring to mind is why am I not dealing with workers or employers who have savings. The simple reason is that the increase in inflation will increase the nominal amount of their earnings sooner or later. Even if the transmission mechanism of inflation to salaries or profits is not perfect and not fully flexible it will be evident sooner or later; besides, just as this transmission mechanism is not perfect the same holds for the one moving interest rates with inflation.

The simple story this post is trying to make is that inflation should not worry the retired. As we have seen, our world is in fact using two schemes which safeguard their wealth: social security schemes and money as a store of value. If only the latter was employed, then people would lose purchasing power in times of higher prices. Yet, their combination safeguards us from such an outcome. Concluding, savers are complaining for no reason at all: their savings may lose purchasing power from inflation occasionally but they are more than compensated for that from their paychecks at the end of each month.

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