Monday Morning: Bad time for rise in personal-saving rate

Good news! The personal-saving rate rose in June to 4.2% of income, from an abysmal 2.3% for all of 2001.

No, wait. That is bad news.

But how can an increase in the personal-saving rate be bad news, especially since politicians and economists have worried for at least the past decade about the nation’s low personal-saving rate?

The answer: Timing.

An increase in the personal-saving rate when the economy is strong and threatening to become overheated would be welcome. Coming at a time when the economy is weak, its effect is similar to bloodletting in a patient already weakened by disease.

It could slow the economic recovery and perhaps even lead to a double-dip recession.

That is because an increase in the personal-saving rate implies a reduction in consumer spending, which is positive when the economy is hot. It also implies a slower recovery than any of us would like at a time when the economy is weak, as it is now, and there is no other increased spending to offset it.

As economists have pointed out repeatedly, consumer spending has provided most of the power for the economy over the past two years, while corporate spending, especially capital investment, has been slashed.

Business investment was down 10.9% in 2001 from the previous year, and down another 5.8% in the first quarter of 2002 and 1.6% in the second quarter, according to the Northern Trust Co.’s economic research department.

Why has the personal-saving rate suddenly surged?

The reason is that the net worth of households has taken a significant hit from the stock market’s plunge, according to Paul Kasriel, the Chicago company’s director of economic research, and Asha Bangalore, an economist there.

In fact, households have experienced two consecutive years of declining net worth, and are well on the way to a third, they note in Northern Trust’s weekly economic commentary.

That is unusual, they say, because from 1953 through 1999, there was never an instance where household net worth declined year over year.

They say there are two reasons the decline in net worth, or the “inverse wealth effect,” might be stronger than many expect.

Seeing is believing

First, individuals aren’t used to declines in net worth. Second, because so many workers have 401(k) plans, the values of which have plunged, they can see that their net worth has dropped.

In the days of defined-benefit pension plans, the value of the assets backing the pension benefit may have plunged, but that was of little concern to the employee.

The value of the benefit to the employee, and hence the part of net worth it represented, was unaffected, because the company and the Pension Benefit Guaranty Corp. underwrote it.

Only if the sponsoring company went bankrupt was the value of the defined-benefit pension affected.

Typically, according to Mr. Kasriel and Ms. Bangalore, the savings rate increases when the ratio of net worth to income declines.

Now that the ratio of net worth to income is falling from the stratosphere, the personal-saving rate is starting to rise, and the two economists expect that the household saving rate could climb back to its long-term rate of 8.7% over the next several years.

However, the economists don’t expect the drop in consumption that saving increase implies to lead to a double-dip recession.

“That’s not the base-case scenario; it’s the worst-case scenario,” Mr. Kasriel says.

The economists forecast real gross-domestic-product annualized growth of 2.5% in the first half of 2003 and 3% in the second half.

That is because the Federal Reserve allowed M2 – money that can be spent immediately plus money invested for the short term, such as money market accounts and money market mutual funds – to grow at a rapid 12.8% annualized rate over the 13 weeks ended July 29.

The bottom line is that the economic recovery probably will be weaker and later than many economists expect, and that may be what the wavering, volatile market is trying to tell us.

Given that, the market may not do much to offset the household-net-worth problem for some time.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.