Breathing room

A rise in interest rates may not be such a bad thing after allProductivity is increasing, gross domestic product is up, employment levels are higher, inflation is low, stocks are hitting record highs - and savings rates are negative. Despite the positive news on the other five fronts, the fact that people are not saving is cause for concern.The savings rate is one of those economic variables that

A rise in interest rates may not be such a bad thing after all

Productivity is increasing, gross domestic product is up, employment levels are higher, inflation is low, stocks are hitting record highs - and savings rates are negative. Despite the positive news on the other five fronts, the fact that people are not saving is cause for concern.

The savings rate is one of those economic variables that is not measured directly, even tough analysts talk about it as if it were. It's actually a residual calculation: disposable income minus purchases and debt payments. So we better be able to measure disposable income, consumption, and debt accurately.

We have pretty reliable ways to measure income and consumption, but debt is another matter. The difficulty lies not in calculation, but in understanding the nature of a specific debt. Debt has a very different impact on the economy when you're talking about home mortgages than when you're talking about money someone borrows to pay for goods and services that someone really can't afford. When debt is used to support "discretionary" consumption, there are limits to how high it can go and still be supported by earned income. When that debt level is reached, consumption - and all the transportation activities related to it - will decline.

Historically, debt-to-income ratios of 15% or lower have been considered acceptable. But this may not be the case today. Increasingly, debt - rather than cash - is being used for day-to-day purchases. Debt-income ratios are currently over 20% - and rising. We're bound to hit the "unacceptable" level before long.

Some purchases are clearly being supported by unearned income derived from the sale of stocks and bonds. The increased value of stocks during the past two years has certainly added to the income stream. But as recent market conditions have shown, people can't rely on it; they have to rely on earned wages. If we want to sustain recent consumption levels, we'll have to increase wages at twice the rate of inflation. But since this would increase inflation, it's not such a good idea.

Which brings us back to why a "negative" savings rate is really the Achilles' heel of recent economic growth. If debt becomes too expensive, the rate of consumption will slow. And if this happens, earnings will decrease - and with them the income stream from stocks and dividends. But we don't know how quickly the change will take place, and which sectors of the economy will bear the brunt of such a slowdown.

So far, the Federal Reserve has managed to hold down inflation while providing enough liquidity for sustained growth. But consumers are testing the limits of this policy. If a substantial increase in interest rates becomes necessary, all payments tied to short-term rates will go up, reducing disposable income.

An increase in short-term rates will eventually be followed by a rise in long-term rates. More stringent credit requirements will mean less capital available for the kind of investments we need to sustain economic growth. Moves to institute rules that reduce the availability of credit to individuals, primarily students who don't have steady jobs, will reduce the pain of uncontrolled short-term consumption among those who really can't afford it. But it also reduces some of the purchases that fuel the economy.

While this might seem like a negative scenario, in the long run it really isn't. A modest decline in the growth rate takes pressure off employment levels and the demand for investment funds. It may even lead to higher profit margins if we no longer have to work overtime to expedite customer support, or suffer quality declines that occur when output is maximized and quality assurance is strained. A little breathing room may be just what we need to get profit margins in better shape.

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