Saturday, 5 March 2011

The Great Savings Fallacy

This blog was sparked by my reading of Richard Murphy's proposals for radical reform of private pensions, Making Pensions Work.  I had to read it a few times to get my head round exactly what it was saying, but in the end it boiled down to the idea that the most effective provision for retirement is made by SPENDING money rather than SAVING it.  Most of the people who commented on his linked blog Making pensions work - don't duck the issues missed this (or chose not to comment), but a few did. The last comment on the blog before it closed essentially said "Saving for retirement is a good thing. We should be encouraging people to do it." This statement runs absolutely contrary to Murphy's proposals - but it is what we are hearing all the time.   People should be saving money, not spending, shouldn't they?

On the BBC's excellent Comic Relief programme the other day, a female slum-dweller was shown an expensive apartment block by the visiting journalist, who asked "wouldn't you like to buy an apartment there"? Her reply was telling. "First, my children must have the best education. Then they will be able to buy me that apartment".

This lady understands the principle of SPENDING to secure her future.  Her future depends on the success of the next generation, and to ensure that, she will put everything she has into getting her children the education they need to succeed. It isn't pure altruism.  She intends to depend on them to support her when she is old.

Now, as an advanced society we have moved  beyond the idea that parents must rely on their children to support them when they are older.  Nowadays we expect the state - in both its public and private dimensions - to fulfil that role.  But the future of the state depends on the success of the next generation - in other words, our children COLLECTIVELY.  The fundamental "pension contract" described in Murphy's paper is therefore essentially the same. We should invest in the future of our economy so that it is successful enough to support us when we are old.  But this is not what we are doing.  We aren't investing in our economy.  We are HOARDING.  That is what "saving" is. Instead of putting our money into our economy we are removing it - at a rate of knots.

We pay a terrible price for this. Parents and grandparents don't spend their money to ensure that their children get an education.  Instead, they squirrel their money away in pension funds and savings accounts. Children are having to pay for higher education themselves, and because of the debt that they will bear as a result they will not be able to support the older generation.  But the return on our pensions is appallingly low - about 1% - and many company pension schemes are in financial trouble and may not pay out sufficient to support us in the manner we expected.  The state isn't able to afford its pension bill either, because state pensions are paid from current tax income and there aren't enough people paying tax to support our growing number of elderly.  So the present pension arrangements will inevitably lead to poverty-stricken elderly, debt-laden adults and few children (because people won't be able to afford them).

Why are we doing this? Partly, it is because we have come to believe that saving is "prudent", and that touches our moral values as a society.  We approve of people who are prudent, who put money aside "for a rainy day". Conversely, we disapprove of people we regard as "spendthrift".  So the concept of SPENDING to support us when we are old runs contrary to many of our most cherished beliefs. 

Another reason why we hoard money, I suggest, arises from the fact that we have forgotten what "saving" and "investing" actually mean.  We use these terms interchangeably, when in fact they are complete opposites.  Investing involves SPENDING in order to generate a future return. Saving involves HOLDING ON to money in some form - including bits of paper that are not called money but behave very like it, such as traded stocks and shares.  So for example, we pay money into our pension funds, which "invest" the money for us in stocks and shares that they buy in the speculative financial markets.  They call these purchases "investments". They are nothing of the kind - they are simply another form of savings.  The process of buying and selling these stocks and shares to "manage the fund" doesn't bring any money into the economy, and does little to improve the long-term return to savers.  All it does is generate short-term profits which are mainly used to line the pockets of market traders and pension fund managers. 

So why do people put their money into these funds? The impression that is given is that if they put their money into these sorts of funds it is "safe" - the returns may be rubbish but at least they are unlikely to lose their capital.  We are encouraged to put money into pensions - including company pensions - and other forms of long-term saving.  Although personal savings plans do advise (in the small print) that "value of investments can go down as well as up", few people appreciate the implications of this. They believe that when they put money into a pension or an ISA, their money is "safe".

Well, that's the great fallacy. THERE IS NO SUCH THING AS RISK-FREE SAVINGS.  Saving money is not "prudent", it is inherently risky.  Even stuffing money under the mattress is not completely risk-free - the value of that money is eroded over time by inflation, and there could of course be a fire or a flood.  But ANY form of savings that generates a return carries some risk to the capital.  Even money in bank deposit accounts is subject to risk.

Deposits in savings accounts, and other forms of supposedly low-risk savings, are guaranteed by the government.  If the bank fails, the depositors won't lose their money - right? Wrong. Yes, the money in the bank will still be there. But they will have paid that money TWICE. That is because it is THEIR TAXES that reimburse the deposit accounts if the bank loses the money.

So how can banks lose money that people put into savings accounts? The popular belief among people who don't understand banking at all is that the money goes into the account and sits there untouched, earning interest.  And that's what the statements suggest.  But they are wrong.  In fact ALL money that is placed on deposit or into savings schemes of any kind is then used by the bank or financial institution to generate more money. That's what pays the interest on your savings - and much more.  You only see a tiny proportion of the amount they make with your money.  They keep the rest.

What do they spend your money on? The popular belief, among those who do at least understand that if you lend a bank money it uses that money for SOMETHING, is that depositors' money is used to fund bank lending. Well, no, it isn't. Actually banks invent the money they lend - a wonderful creative accounting system called fractional reserve lending.  Why on earth would they lend out depositors' money when they can create new money for lending and keep the depositors' money for other purposes?

What they actually spend your money on is gambling on the world's largest casino.  If you have a long-term savings account such as a stocks & shares ISA, or a personal pension, or a "money purchase" company pension, you know they are doing this because they tell you that they are "investing" the money in stocks and shares.  But if your savings account is a cash account, or you have a "final salary" company pension, they don't tell you what they do with the money at all.  Actually they do exactly the same thing with the money.

So your supposedly "safe" savings are not safe at all - as all too many people have found out. Pension shortfall is a reality for all too many people, and savings accounts are at risk too. Rather than shouting "foul" about this, though, it's time that people woke up to the reality that HOARDING their money is not a good way of investing for their retirement. It would be better if that money was openly SPENT on things that generate a good return both to the economy and to them.

Murphy's paper suggests a fundamental change to the way in which pensions and other forms of long-term savings work.  The change isn't major from the investors' point of view, though they would need to understand that they are providing RISK CAPITAL - they may not get their money back.  People would still pay into company or personal pensions, or other forms of long-term investment.  But suppose that instead of buying and selling stocks and shares on the financial markets, which is of course a SECONDARY marketplace, our pension funds were to buy newly-issued shares and bonds? The money they spend on these would go directly to the institution that issues the shares or bonds.  Approximately 40% of pension fund investments are gilts - UK government debt bonds.  If these were purchased directly from the government rather than from the secondary marketplace, that money would go to the government for use in public works, instead of into the pockets of bankers and market traders.

"But wait," I hear you say, "once you've spent that money, it's gone.  How are you going to pay out when the pension or savings plan reaches maturity?"  Well, government bonds can of course be sold on in the secondary marketplace.  Ideally, though, pension funds would hold bonds to maturity, which would require some matching of maturity profiles between pensions and bonds.  Hopefully in the time that the pension fund holds those bonds, the public works that the money is spent on will generate a sufficient return not only to pay back the capital but to provide a decent income for the pensioner.  That is where the risk lies.  Is that a worse risk than the those we already carry, that until recently we didn't know we carried - that the financial markets would collapse and we would lose our savings, and that the return on our "investments" is so low that it doesn't provide adequately for our old age anyway?

Whatever pension funds and issuers of ISAs invest in, the deal has to be that the money is used directly to benefit the economy.  Murphy to my mind goes too far in implying that pension funds should ONLY invest in the public sector - gilts, local authority bonds to fund regeneration, a Green Investment Bank to support carbon reduction and other green initiatives, replacement of PFI initiatives.  I don't have a problem with pension funds investing in these, but equally I don't see why they shouldn't also invest in shares and bonds issued by carefully-selected private companies who are not providing services directly to the public sector.  Our economy grows through private investment as well as public, after all.  Obviously there are ethical concerns here, but we have those already! The point however is that whatever they invest in should be NEWLY ISSUED and held long-term, ideally to maturity in the case of bonds, and that the money should be used to create real jobs, develop new products, improve infrastructure - and yes, I believe, fund education.

I'm aware that what I am suggesting here is controversial.  I can see the headlines now: "GOVERNMENT RAIDS PENSION FUNDS TO BAIL OUT DEBT-LADEN STUDENTS" - or maybe: "NEW PENSION FUND REGULATIONS WILL DESTROY FINANCIAL MARKETS, SAYS EXPERT".  This was one of the objections raised against Murphy's paper. It requires some explanation.

We are led to believe that gambling on the financial markets generates loadsamoney for the economy.  In terms of actual tax paid, that is true.  But it is necessary here to take into account the opportunity cost of the loss of investment to the economy because of the money that is sloshing around the City.  Given that virtually all forms of savings generate their returns by gambling on the financial markets, this cost is ENORMOUS. Because of this there is an obvious problem with reducing or eliminating trading by pension funds and other long-term customer savings schemes in the secondary financial markets.  They provide a serious amount of money to that marketplace.  Without them it will be a shadow of its former self. 

At present the financial markets are not exactly popular, so many people reading this will say "so what if they disappear - good riddance".  But the financial markets serve a useful function. Among other things, without them it would be very difficult for example to sell on shares that you no longer wish to hold. I had to sell some shares that I'd inherited in order to pay an unexpected tax bill last year. If the secondary market in shares didn't exist I would not have been able to do this.  We need to ensure that there is sufficient movement in the financial markets for them to continue to provide essential liquidity and risk management services to companies and individuals (more on this in another blog).  But they don't need to be the size that they are, nor should they dominate our economy as they do. Exactly how severe the effect of losing pension fund and long-term savings activity would be on the financial markets is unclear. But they would obviously shrink significantly.  There would also be a significant change in the profile of shareholdings in large companies, since at present the major shareholders are pension funds.  Who or what would replace pension funds as shareholders is unclear.  All of this needs to be thought through and managed because of the potential effect on the economy of such a major change to the markets that - whether we like it or not - lie at the heart of our financial system.

And finally I have a few remarks to make about the economic implications of all of this. 

I don't pretend to be an economist, but I do have a basic grasp of economic principles - enough to know that when you remove money from an economy, it shrinks.  Up until recently the progressive removal of money from the UK economy through savings (including pensions) has been offset mainly by inflation in house prices and excessive returns from high-risk activitiy on the financial markets.  Both of these have now collapsed and as a result Britain is currently hovering on the edge of recession.  In these circumstances encouraging people to save is, frankly, folly.  The way to get money into the economy is to encourage people to spend.  Murphy's proposal in effect converts long-term savings activity into spending into the economy. This makes economic sense.  But does it make sense in terms of providing for our increasing number of pensioners? Murphy's analysis suggests that it might - but at a cost of completely changing how our financial system works, and upsetting a lot of people who really believe that saving is a "good thing".  It's a huge risk.  Is it a risk we are prepared to take?

By the way, the idea that investing (i.e. spending) to achieve a return is better than saving is hardly new. It's in the Bible - Matthew 24: 14-30 ( even includes a nice plug for banks - odd in a society where lending at usury was illegal!). Christians usually interpret this to mean "talents" in the sense of abilities, which gets them off the hook because "saving" is often regarded as a Christian virtue.  But Jesus could simply have been talking economics.....