Macro Economics – Encourage People To Save Part II

In Part I, I went over some very basics on how banks work, and ended with introducing inflation into the mix. The last questions I asked was: Now everybody’s hurting some, right?

Wrong.

Banks are for-profit businesses.

Banks have lots of smart number-crunchers working for them. They pick an interest rate that they charge for loaning out your money that allows them to not only fund their expenses, but also make a tidy profit and thereby increasing their purchasing and lending power in spite of inflation.

Savers aren’t quite so lucky. The savers’ purchasing power goes down if the saver leaves the money in the bank.

This leads to the bank’s greatest fear: Savers taking their money out of the bank all at once.

See, in our overly-simplified example, the bank has less than the $1000 plus savers’ interest available at any given time. (Remember, for this example, the bank wants to keep about 30% of the assets loaned out at all times so it can collect interest and fees on those loans to pay itself and then the savers.)

If 80% of the savers take their money out of the bank in one month, the bank is in trouble.

  • It doesn’t have enough money to give those savers *their* money back – like the bank is required to under the agreement with the saver.
  • It hasn’t saved enough of its own profits to make up the difference. The bank is now in debt – it owes money.
  • We call this “bankrupt”. The bank doesn’t have enough money to cover the debts.

(This is why banks tend to offer better rates on CD’s – they’re guaranteed to have the savers’ money to loan out for that period of time, and can use those assets to cover themselves better. It’s less risk for the bank, less risk for the saver.)

Bluntly, the banks want to pay savers (the asset providers) the absolute lowest possible return, and charge lenders (borrowers) the absolute highest possible fees. The monetary difference becomes the gross profit/loss for the bank.

Now comes the trick that short-sightedness misses: Banks need more savers to give them the new assets that they can then loan out and use to generate profit.

But banks and the Federal Reserve have been punishing savers by paying very low rates to savers for providing those assets. Those assets have declined in value due to inflation. A certain percentage of savers noticed this, and moved their money to greener pastures. This had the net effect of reducing the bank’s total pool of assets (influation plus losing savers).

(Yes, I know that there’s a LOT more to it than this. Please bear with me, and remember that my focus is on people like me – savers.)

With a smaller pool of assets relative to their loans, banks are harmed more by defaults on those loans, and by people losing confidence/trust in the financial safety of the bank. The net result is more and more savers start moving their savings out of the bank, the bank’s asset pool shrinks more, the risks increase for the bank, who charges higher interest on the loans, resulting in fewer borrowers providing profit to the bank, and makes it even harder to regain savers’ confidence/trust to give the bank more assets. When financial institutions started buying and selling “securities” (basically, selling loans as if they were stocks), they started going beyond their core business of money management and jumped headfirst into gambling: When the price of those securities drops below what a financial institution paid for them, the institution just lost some of its critical reserves — the savers’ money entrusted to their care.

So this boils down to one essential question:

Why would anyone keep their savings in a bank?

1. Safety. The FDIC insurance means that, if the bank goes under, the savers will get up to a certain amount of that money back courtesy of the United States Taxpayers (currently set at $250,000 maximum, though historically it’s set at $100,000 per institution).

2. Habit. Growing up, my generation was hammered with the “save it in a bank” mantra. Don’t think about why you would want to save it in a bank — just do it without asking any questions.

3. Inertia. Once a person makes a decision, especially a “safe” decision, we are loathe to change it.

People, savers, do eventually wise up and start moving their savings elsewhere to get better returns.

This, of course, makes lots of trouble for the banks.

Got all that?

Okay, now look at the reverse: What if savings earned a higher-than-inflation rate of return?

Then we have the opposite problem for the bank. The bank has to loan out assets at higher interest rates in order to cover costs (such as paying the savers that Inflation+ percent) and make a profit. Always remember that banks are for-profit businesses.

Since the cost of the loan is now so much higher than infaltion, fewer people/businesses will ask for loans — it’s better for them to become savers than borrowers. Now the bank has a harder time lending out money, makes less profit, and eventually can’t afford to pay its employees or savers.

The net result of this is that any savings account that earns a return too far below inflation is bad for both savers (due to inflation) and banks (due to the presence of higher-interest accounts that are closer to inflation level or higher). This result, however, is worse for savers.

The break-even point, savers getting the inflation rate, is constantly moving, and less profitable for the banks (businesses exist to maximize profits within the constraints of law and good sense. Banks are businesses.) Therefore, it seems to me that the best savings interest point is 2/3 to 3/4 of the last 10 years of average inflation. At this level, the assets provided by savers or profits from bank operations, aren’t deteriorating as much due to corrosive inflation. And the bank’s ability to generate profits (the bank’s main reason for existing in the first place) is still solid and reliable.

But I don’t think that banks, even the theoretical overly generous and conservative bank in our simple example, will raise their savings interest rates at their rock pile centers that high. It would cut too much into their profits (and reduce executive compensation by millions – a crime beyond imagining).

So for these reasons, I think savers should understand and do the following:

  1. Savings are not an asset because of inflation. As long as inflation is higher than the rate of return on your account, you are losing purchasing power. That’s a continuing expense.
  2. Use savings accounts only for short term goals (1-2 years at most) and as an emergency fund. There are better alternatives for both of those, but they require more effort on savers’ part.
  3. Put your savings in the highest interest account that you can, or ladder them as CDs that earn as close to or more than the inflation rate.
  4. Stop being just a consumer. If all you do is consume, you never produce anything of net worth.
  5. Stop being just a saver in mindset. You’ll never get ahead being just a saver.
  6. Start being a frugal investor in mindset (Pookah Finances 201 and 301).

Now, what should you take away from all this? Two basic things:

1. A better understanding about banks in relation to savers and our current (and developing) economic situation as a nation. Well-run banks are NOT your enemy; but they are not your ally either. They are in it for the money.

2. Motivation to take an active role in your own finances.

One Response to “Macro Economics – Encourage People To Save Part II”

  1. Branden says:

    If you’re talking about sivang money on electricity bills, turn off the air conditioning in the lecture halls. It’s ridiculous. Everyone is freezing. We can’t take off our jackets. It’s on so high our hair is blowing in the wind. We can’t concentrate. PLEASE!

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