Blogs | September 23, 2013

Is saving worth it?

Why bother saving? When cash savings rates are below inflation, millions ask this question. But it misses the point.

We don’t save merely – or even perhaps mainly – to earn a return. We do so to transport money from our present self to our future self. China does not stop exporting goods simply because it costs money to transport stuff from Shanghai to Houston. Nor, then, should we stop transporting money to our future self simply because it costs us to do so.

Future proof you: why money should time travel
This is because there are, at least, two major reasons to do this. One, of course, is simply that we’ll need money in our retirement; work does not become more pleasant with age, so your future self might well want to retire early. The second is that our future self might need the money because he or she could lose his job. This risk is significant.

US figures show that, in June 2013, 1.4% of American workers lost their jobs involuntarily. In the UK in the second quarter, 3% did so. It would be wrong to annualise these numbers – doing so implies a 10-15% annual rise of being sacked – because some people move regularly between work and unemployment while others are in more secure work.

Nevertheless, they remind us that there’s a significant risk that our future self could suffer a big fall in income – a risk which our optimism bias can cause us to understate. Here, we should remember why interest rates are low. It’s because central bankers believe the economic recovery will be weak. But in this case, job insecurity is high and so we have an extra reason to save.

Cracking saving habits – now and in the future
This poses the question: if the reasons to save are so strong, why do we save so little? One good reason is that, for many of us, our incomes are so low that we can’t afford to. But there are some less good reasons. One is the present bias – our tendency to give our current self more weight than our future one. Researchers have found that this bias is especially big if we are feeling low; there’s a reason why shopping is sometimes called retail therapy.

A second is the projection bias – our tendency to project our current tastes into the future, and so underestimate the extent to which our preferences will change. This can cause us to spend too much on cars and TVs, because we fail to foresee that we’ll get less pleasure from them as we get used to them.

A dream car now or a comfy retirement?
One reason why interest rates are normally above inflation may be that these biases often cause us to spend a lot and save a little, and so we need an inducement to save.

Now, you might reply here that my transport analogy has an obvious implication. Just as a rise in transport costs could cause some Chinese exporters to stop shipping goods to the US, so a higher cost of transporting goods to our future self – that is, a more negative interest rate - should cause some of us to reduce the amount we transport. Not necessarily.

There is a struggle, in economists’ jargon, between the “income effect” and the “substitution effect”. If our future self needs a particular income – say to retire on or to buy a car with – then our present self might want to save more when interest rates are low, to give that income. Yes, the substitution effect tells us that we should substitute away from saving when interest rates are low. But the income effect tells us we should save more.

So, is saving worth it?
Which of these effects is most powerful? Of course, it’ll differ from person to person depending upon why they are saving and how much they want to buy stuff today. One big historical fact, though, tells us that the income effect can be important. In the 1970s, when inflation rose sharply and real interest rates became very negative, people saved more – the income effect was bigger than the substitution effect.

So yes, there are still good reasons to save, even though there are costs of doing so.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist