What next?

One Salent Oversight notes:
Low savings rates are the main cause of the current crisis. Moreover,
the previous recession caused by the tech boom was also a result of a
failure to save. The US economy (and others) have discouraged savings,
which has resulted in an overinvestment in high risk ventures (such as
asset price bubbles).

Had savings rates been higher from the early 1990s onwards, both the
tech boom and bust and the subprime bubble and current crisis would have
been averted.

The best way to reward the market for saving is to have higher interest
rates. Ensuring that real interest rates remain positive at all times
and using monetary policy to ensure absolute price stability (neither
inflation nor deflation over the course of the business cycle) is the
best solution in my opinion.
America’s (and the world’s) economy created this crisis because
something within the system created the conditions that led to this
disaster. This is important to realise because, when the time comes to
stop reacting to daily crises and start examining why the failure
occurred, there will arise a series of solutions that will help prevent
a similar event occurring again.

It is not as though market capitalism has failed – as far as I am
concerned market capitalism fails all the time. Abandoning capitalism
for, say, Communism is about as judicious a decision as eating pebbles
to cure an infection that has developed a resistance to antibiotics.

Put simply, the current crisis was caused by people with lots of money
who invested it in the wrong thing. The people thought they were doing
the right thing because the numbers looked right, the ratings agencies
gave AAA ratings, the majority of respectable financial analysts said is
was the best thing to do and the Joneses next door were making a killing
from it. Herd behaviour? Yes. But herd behaviour that had careful
planning behind it.

The structural problem resulted in the market investing unwisely.
Investments were made in particular areas (shares, property) that seemed
wise at the time but ended up going bad. While we may expect high return
investments to be highly risky, the same could not be said for low
return investments – which are now in free-fall too.
Cash ought to be the safest form of investment. There has to be some
sort of low or zero risk investment that people can make. It’s not wrong
to invest in shares or property – it’s just important that a percentage
of surplus cash remain in cash form.

Having money tied up in cash is not very sexy. The interest you gain on
it is nowhere near as potentially rewarding as a higher risk investment.
Yet the issue is not whether cash investments replace other investments
– but having a healthy mix of the two.

Cash investments are meant to be safe. They are not meant to reduce in
value. If you have $10,000 sitting in a cash management trust you are
not meant to watch it drop down to $9000. Any cash you have sitting in
an account that remains uninvested in anything else should, at the very
least, have the same value when you withdraw it as when you deposited it.

And cash – savings – is useful as a “safety net” when things go wrong.
Everyone knows the importance of having more cash flow available than
what you need normally because of the danger of unforeseen events. The
best place to access this cash flow is from interest-bearing accounts
that you have saved up over time (rather than, say, maxing out your
credit card).

Yet here is where the structural problems come in: Americans (and many
others) did not invest their cash surplus in savings but put them into
risky investments that have since lost money. This was not a moral
failure, but a practice that the entire economy encouraged.
Had (positive real interest rates and absolute price stability) been the
Fed’s policies from the early 1990s onwards, there would not have been
either the tech boom and bust nor the subprime mortgage crisis and
today’s credit crunch. GDP growth during this period would have been
lower, certainly, but considering the potential cliff that GDP is likely
to plummet in the present, this would have been a better outcome.
Moreover, savings rates would have been high and credit market debt
would have been more sustainable.

I honestly don’t know what is going to happen to the world economy over
the next day, month or even year. What I do know is that, once a
recovery is underway, new policies and paradigms will need to be
explored to prevent this financial horror story from occurring again.
Increasing household savings is one major step in this direction – and
this is best handled by using interest rates to affect broad market
behaviour rather than creating legislation to force people to save.