The Biggest Paradox of All

Good news. No, great news!

The personal savings rate is exploding. In fact, we saved more in the last three months of 2008 than in all of 2005 and most of 2006 combined. Consumers saved an annualized $310 billion last quarter, or 2.9% of disposable income. As a percentage of disposable income, that was the highest rate since early 2002.

Why is this so important? "Address the root cause of the problem, not just the symptoms," wise folk tell us. That's exactly what higher personal savings does. After months of throwing billions of dollars at Citigroup (NYSE: C  ) and Bank of America's (NYSE: BAC  ) symptoms, the surge in personal savings is the first -- and most important -- step in fixing an economy infatuated with debt. Stop spending. Start saving. Less consumption. More security. Save today, and we'll be singing “Kumbaya” tomorrow. Right?

Easy there
While it’s absolutely true that the surge in personal savings is a huge step in the right direction, examining the effect it's had on the economy brings to light some ominous signs.

As consumers converted from spenders to savers in a matter of months, the economy fell off a cliff to an extent we haven't seen in decades. Excluding inventories, real GDP fell 5.1% in the fourth quarter. Pfizer (NYSE: PFE  ) , Boeing (NYSE: BA  ) , and Microsoft (Nasdaq: MSFT  ) , among countless others, axed tens of thousands of jobs. Companies that rely exclusively on consumer spending -- such as American Express (NYSE: AXP  ) and Macy's (NYSE: M  ) -- now trade at their lowest levels in well over a decade.

There are obviously more factors involved here, but consumers’ slamming their wallets shut has been a driving force in the economy's collapse. In an economy that derives 70% of GDP from consumer spending, the correlation between increased savings and economic fallout is painfully clear.

"[We need to] break the vicious cycle where lost jobs lead to people spending less money which leads to even more layoffs," President Obama recently warned. So, following that logic, the road to success ultimately means consumers spending more money?

No.
That's where things get dicey. A 2.9% personal savings rate is certainly a step in the right direction, but it hardly meets anyone's definition of adequate.

Going back to 1947, the average savings rate is 6.9%. In more dire economic times, the personal savings typically hovers near 10%. By almost any historical measure, our current "increase" to 2.9% still qualifies as an abysmally pathetic number.

Hence, one of the biggest paradoxes of our economy today:

  • We have to save more money to get back on a sustainable track.
  • How much more? Using historical averages, probably along the lines of twice as much as we do today.
  • Yet just the recent increase to 2.9% sent our economy into a tailspin. What will doubling that amount -- if not more -- do to our consumer-centric economy? I don't even want to think about it.

Getting personal savings up to historical averages entails diverting money that may have otherwise gone to consumer spending -- the economy's lifeblood in recent years. How much more? Have a look:

Personal savings rate

Potential money diverted from consumer spending

2.9%

$310 billion

5%

$534 billion

8%

$855 billion

10%

$1.69 trillion

Source: The Bureau of Economic Analysis.

Round 2
The puzzle only gets more troubling when you factor in the trillions of dollars of government spending measures in the pipeline. The money Washington throws around has to come from somewhere. Where? Printing presses -- or someone's savings. For the past decade, that someone has been China, OPEC nations, and other global investors.

In the coming years, however, that free ride on other people's money will likely ebb as countries keep cash at home to develop their own economies, as China's recent $586 billion bailout proves. More savings, in other words, will need to come from our own pockets.

Round 3  
Another aspect of this pickle is the zilch return you can get from savings products today. With a Fed funds rate at or around zero and Treasury notes yielding close to nothing, the incentive to save today is driven predominately by fear of economic fallout more than sensible investing strategies.  

That’s all well and good. But what happens when that fear of the apocalypse subsides? To justify saving, investors -- domestic and especially international -- will start to demand higher interest rates, exacerbating an already brittle financial system and thumping a real estate market littered with adjustable-rate mortgage products.

Bottom line
I'm thrilled consumers are saving money again. You should be too.  Nonetheless, the evidence overwhelmingly indicates that it’s still not nearly enough, and getting to "enough" is having serious downside effects on the economy. In the long run, yes, it's all for the better. In the short run, these are paradigm shifts that, for many people, are going to be extremely difficult to adjust to.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Pfizer is a Motley Fool Income Investor selection. Bank of America is a former Income Investor recommendation. Pfizer, Microsoft, and American Express are Inside Value selections. The Fool owns shares of American Express. The Motley Fool is investors writing for investors.


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  • Report this Comment On February 12, 2009, at 9:49 PM, SteveTheInvestor wrote:

    The real drivers of the consumer economy are the middle class. Many can't afford to save a lot of money. They are either out of a job or trying to pay off their pile of debt. I don't see the savings rate going up much more for some time.

  • Report this Comment On February 12, 2009, at 11:09 PM, trenton1ryan wrote:

    < these are paradigm shifts>

    This is what's really happening. Things will never be the same again (not in our lifetime anyway).

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