Earning, Saving and Giving: Have We Lost Our Way?

By Ken Washer, DBA, CFA
Associate Professor of Finance

The Christian theologian and founder of the Methodist Church, John Wesley, preached: “Earn all you can, save all you can, and give all you can.” He encouraged hard work in “honest industry,” along with limited spending. Wesley argued that to not use your money to support a good cause is to simply “throw it away.”

Are these sound economic principles that we should pass on to the next generation or are they impediments to economic growth? Do we Americans live these values or has our motto instead become, “Borrow all you can, spend all you can, receive all you can”? Perhaps it is not that extreme, but our society appears to be moving in that direction.

Borrow All You Can?
We are undoubtedly a nation of debtors and too much of the wrong kind of debt is troubling. Revolving debt often represents the bad kind of debt, as it is generally used to purchase consumption goods. Credit cards are a good example of revolving debt, as no fixed, regular payments are required.

Revolving credit increased from $561 billion in June 1998 to $965 billion in June 2008 — a 72 percent increase! This higher level of debt seemed manageable relative to the peak values of our houses and retirement accounts. Times were good for many Americans and our fear of debt low. Credit was abundant and access was relatively easy.

Things changed in 2008 as real estate prices fell and the stock market cratered. Our debt now seems excessive relative to assets and income and must be reduced.

The U.S. government has also gone on a borrowing binge. In September 2008, total U.S. federal debt surpassed $10 trillion, which works out to about $32,900 per U.S. resident. The debt picture is much worse when you add unfunded liabilities such as Social Security and Medicare, ballooning to more than $500,000 per person.

The Government Accountability Office, U.S. Treasury Department, and Office of Management and Budget all agree that the government’s current fiscal activities are unsustainable. Financial issues surrounding Social Security, Medicare and Medicaid become more severe the longer we delay in addressing them.

The good news about debt is that it is not always harmful. Young people borrowing money so they can attend college and earn a degree are often making a wise decision. The returns from an education are generally much higher than the interest paid on the student loan. Education not only improves one’s life, it also leads to a smarter and more productive workforce, which strengthens our great nation.

Another example of good debt is borrowing to build or expand a business. This entrepreneurial activity creates jobs and meets societal wants and needs. The return on investment can greatly exceed the interest rate paid on the loan.

Debt is troubling when we undertake it to live beyond our means. Advertisers are excellent at convincing us that we need and deserve certain luxuries. Many of us spend more than necessary on a car or trade it in too soon. We splurge today, only to work for our creditors tomorrow.

The table above (click on the image to enlarge) shows the current account balance for the U.S. from 1960 through 2007 as a percent of Gross Domestic Product (GDP). The current account is roughly equal to what we sell to the world (our exports) minus what we buy from the world (our imports). Our foreign purchases have exceeded our sales since the early 1980s.

The U.S. has benefited through lower inflation rates, and foreigners have gained through increased production and job creation in their countries.

If an individual spends more than he earns, his “current account” would be negative. To make up for this imbalance, he must either borrow money or reduce his savings.

Likewise, if the U.S. imports more than it exports, it must either borrow from the rest of the world and/or decrease its holdings of gold and foreign currencies. Our foreign reserves change modestly, so the current account deficit is financed by foreigners.

The critical question is whether America is borrowing money to live better now or to live better later? In other words, are we spending the borrowed funds on consumption goods or are we investing the funds to increase our productive capacity?

In 2007, investment expenditures in the U.S. exceeded domestic savings by about $600 billion, so without foreign money many business expansion projects, student loans and mortgages would have gone unfunded. Thus, one can argue that the foreign borrowing was put to good use.

The current account deficit has accelerated over the past 15 years. One implication of this is that foreigners are putting a lot of money into (supporting) U.S. debt and equity markets. If they were to reduce their investments in the U.S., the dollar would weaken and security prices would fall.

The benefit of a weaker dollar is primarily through a more competitive price for our exports in world markets. Manufactured goods such as U.S. airplanes become cheaper in Europe, Asia and elsewhere. This leads to more jobs at home.

The main disadvantage is that imports into the U.S. become more expensive, leading to higher inflation and higher interest rates. In essence, what we buy from the world becomes more expensive and what we sell to the world becomes cheaper.

The total U.S. government debt approached 40 percent of GDP in 2007 and with the financial crisis that began in 2008 should approach 50 percent of GDP soon. (Total debt does not include unfunded government programs like Medicare.) An individual or a business having debt equaling 50 percent of annual income is not overwhelming.

Some economists are not overly concerned by this high debt load because: 1) Japan’s debt to GDP ratio is much higher (over 100 percent) and 2) during World War II our debt burden was over 100 percent of GDP and was manageable.

Other economists remain worried because it is unlikely that the trend will be reversed or even stabilized with huge government outflows projected for Social Security and Medicare payments going to/for baby boomers in the near future.

We are a debtor nation, but the good news is that much of the outstanding debt has been used on investments, not consumption. Going forward, though, Social Security and Medicare spending will not enhance our productive capacity and is a major concern. Without modifications, these programs will push our debt levels to unprecedented levels.

Spend All You Can?
Benjamin Franklin famously said, “A penny saved is a penny earned.” The more we save today, the less we will need to earn tomorrow to maintain our standard of living.

Boomers are undoubtedly less frugal than their Depression-era parents. In 2005, the average 50 year old had $122,000 of debt, which was 2.5 times more than his 1985 counterpart (adjusted for inflation).

Some economists have suggested that boomers are at least partly responsible for the recent turmoil in the real estate market and the stock market. They are entering a stage of life where income and spending decline, and big homes get sold. Retirement accounts get “drawn on” instead of “added to.”

The table above (click on the image to enlarge) shows that the U.S. savings rate was well over 8 percent for much of the 1970s and 1980s indicating that people saved about $9 for every $100 of disposable income. This rate has fallen precipitously over the last two decades (it was even negative for a quarter in 2005) and was below 2 percent in the third quarter of 2008.

One of the most striking things about the chart is the huge disconnect between the growth rate in disposable income and the savings rate in the late 1990s and 2000s. This is partly explained by the stock market boom throughout the 1990s and the real estate gains made earlier this decade. People felt wealthier due to increases in their retirement accounts and home valuations, and therefore they reduced the amount they saved.

Many people’s wealth has decreased considerably during the financial crisis that began in 2008, and many economists anticipate the savings rate to rise. Americans have reduced spending in order to increase savings and/or pay down debt. This has disrupted the world economy and significantly reduced sales and profitability of many companies.

During times of economic crisis consumers are often wrongly encouraged to open their wallets and spend. The U.S. government doled out $105 billion in rebate checks in the summer of 2008 and hoped Americans would go shopping. We did, but the effects were short-lived as spending dropped off shortly thereafter.

During downturns, an economy can get in a vicious cycle of consumers cutting back, followed by businesses cutting back, followed by consumers cutting back more, followed by … you get the picture. The stimulus plan attempts to end this cycle. However, if consumers are really in financial trouble from too much debt accumulation and falling portfolio values, is it healthy to mislead businesses? It seems as if we are only postponing the inevitable (perhaps even making it worse).

At times, it is very easy to believe that spending will cure our economic woes. However, economic growth does not come from increased spending. If that were the case, spendthrifts would be billionaires and Warren Buffett would be in the poor house.

The objective of a government stimulus plan is to promote economic growth. However, consumer spending does not accomplish this. Brian Riedl, a fellow at the Heritage Foundation, wrote recently in the Wall Street Journal that, “productivity growth requires a motivated and educated workforce, sufficient levels of capital equipment and technology, a solid infrastructure, and a legal system and rule of law sufficient to enforce contracts.” Lowering marginal tax rates, instead of rebate checks, motivates workers and encourages investment in equipment and technology.

The way to economic prosperity is through saving, not spending. China has been one of the fastest-growing economies in the world recently and its standard of living is well below ours. The Chinese finance much of our spending, as the average Chinese saves 40 percent of his or her income.

We also cannot continue to count on foreign investment. As capital markets continue to develop, foreigners will have additional investment opportunities. At the end of 2007, Japan and China owned about 25 percent of U.S. government debt. They may decide that the U.S. is not the best place to invest. Fast-growing economies in Asia or South America may attain capital that now flows to the U.S.

Much of worldwide production has been focused on the U.S. consumer. Our easy access to credit coupled with rapidly expanding real estate prices allowed us to consume at levels that are unsustainable in light of the bursting of the real estate bubble. The world economy will rebound once businesses redeploy productive resources that focus more on consumers throughout the world and less on Americans.

The U.S. government seems to have bought into the mantra of “spend all you can.” The government deficit for fiscal year 2008 was $455 billion (3.2 percent of GDP) and is projected to increase to $750 billion (5.5 percent of GDP) in 2009. Barring restraint in spending by the government, the value of the U.S. dollar will likely fall in the years to come.

Wisconsin Rep. Paul Ryan encouraged his fellow representatives “to refocus our efforts on pursuing policies that strengthen our economy, and on getting our own spending under control.”

Receive All You Can?
We are a nation in debt and we do have a spending problem, but Americans are also very generous. Several studies estimate that 70 to 80 percent of American families give annually to charities. The Center for Philanthropy at Indiana University estimates that in 2006 total charitable donations equaled 2.2 percent of GDP, which was up from 1.8 percent during the mid-1970s to mid-1990s.

The Organization for Economic Cooperation and Development estimates that the U.S. government donated $23.5 billion in 2006 for Official Development Assistance. These funds go to countries like Afghanistan to help improve national security. Aid also goes to poor countries to fight diseases such as HIV/AIDS and malaria. The amount given by the U.S. is often twice that of the next largest donor nation.

Not to be outdone by their government, international aid from American citizens and private institutions (foundations, businesses, religious organizations) is often two to three times that of government aid. In 2006, private donations exceeded $34 billion.

Why, exactly, do rational people donate their hard-earned money so freely? Is it for the tax deduction or because they believe in the cause? In the late 1980s, an economist named James Andreoni suggested that people give because it simply gives them a “warm glow.”

People don’t just give money to Creighton University because they believe in higher education. They give to Creighton to be aligned with a topnotch private university. They become part of the Creighton family, and this makes them feel good. They are not just changing young people’s lives with their donations, but they are also uniting with a group that changes lives.

A person may believe that feeding the hungry in Africa is of utmost importance yet choose other causes to support because of the “warm glow.” It may be much harder for this person to connect with the African aid supporters and interact with like-minded people.

John Wesley was indeed correct when he preached to earn all you can through honest labor, save all you can through disciplined spending and give all you can to worthy causes. When we live these things, we not only benefit ourselves, but we benefit the world.

A society that works produces goods and services that improve the quality of virtually everyone’s life. A society that saves provides funds for others to purchase a house, get an education or expand a business. A society that gives understands that some people are not able to provide for themselves and need a helping hand.

Perhaps the recent financial crisis will be the catalyst that pulls us back toward these virtues.