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Mind the gap

Big numbers are always striking and there are few things more striking than the claim that a £27bn gap exists between what people need to be putting aside for retirement and what is actually being saved in the UK.

This claim by the ABI has become a familiar feature of the landscape. It is important, therefore, to understand why the whole concept of a national “savings gap” might potentially be highly misleading.

It is relatively easy for most of us to understand the idea of a savings gap at the level of our own personal finances. We all have certain expectations of when we would like to retire and what kind of living standards we would like to enjoy in retirement.

One key function of personal financial advice is to set out for people what level of saving they may need to undertake in order to realise those expectations.

It is often sobering for us as individuals to be told that we are saving significantly less than we need to meet our retirement aspirations – that rather than saving 10 per cent of salary we really need to be saving 15 or 20 per cent. This is the concept of the savings gap at the level of the individual.

It seems entirely reasonable to sum up all the individual savings gaps to get an aggregate figure for the total UK of £27bn. However, it is entirely wrong to do so.

The first person really to ram home the point that what makes sense for the individual may not necessarily make sense for the aggregate economy was the economist John Maynard Keynes in the 1930s. Indeed, he used savings as the example and called it the “paradox of thrift”.

Keynes outlined an example of where aggregate saving in an economy jumps up as individuals suddenly all decide to save more. As saving and consumption are the exact counterparts of each other, this jump in aggregate saving has to be matched exactly by an equivalent fall in aggregate consumption.

Keynes suggested that a sudden fall in sales as consumers spend less will lead firms to cut back their investment. The economy will shrink and, far from greater thrift leading to greater prosperity, it could lead to a slump.

This is not just a theoretical possibility, it is part of the explanation of why the Japanese economy has remained stagnant for a decade. Fears about the economy, job security and the consequences of an ageing population have led households to try and increase their savings. But these attempts have reduced aggregate consumption and demand in the Japanese economy, contributing to its continued stagnation.

Now, of course, there is a different macro-economic story one could tell. Extra saving for retirement at the household level, if it was not offset by less saving for other purposes or less saving elsewhere in the economy (by firms or the Government) should generate more funds for investment.

If firms have been capital-constrained, these extra funds could lead to higher investment by easing those constraints. The savings could also flow abroad to fund productive investment overseas, leading to an eventual flow of returns back to the originating country.

So, one can tell different macro-economic stories about the impact of higher aggregate saving and lower aggregate consumption. The key is explaining exactly how the increase in aggregate saving and fall in aggregate consumption will lead to a higher level of gross national income in future, enabling a more generous retirement to be enjoyed by all.

However, the simple story of the £27bn savings gap does not appear to be matched by any macro-economic story at all. How do proponents of the savings gap expect the economy to react to a fall in aggregate consumption equal to over 2.5 percentage points of GDP? Where will the fall in consumption take place? What will be the response of firms? How will the increase in aggregate saving be translated into an increase in productive investment, domestically or abroad?

None of this is meant to detract from the important role that financial advice plays in carefully matching individuals&#39 expectations with their savings behaviour. Each of us does indeed need to think carefully about trading off our current consumption against future consumption.

But – and it is a big but – one of the lessons of basic macro-economics is that you can never simply sum up what might be rational at the individual level to what might be rational at the level of the whole economy. That is why talk of a national savings gap is at best naive and at worst quite misleading.

Peter Robinson is chief economist at the Institute for Public Policy Research


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