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November 11, 1983
Saving,Investment,and Deficits
The Federal budget deficit normally tends to
decline in cyclical economic expansions
because tax receipts rise and expenditures
(such as unemployment compensation) fall
with the increase in the level of economic
activity. Currently, the Congressional
Budget Office estimates that the Federal
budget deficit would fall from 6 percent of
G N P in 1983 to 5 percent in 1984 and 1985,
and 3 percent in 1986, if the budget resolution adopted in June were implemented.
To evaluate the economic impact of these
budget projections, we must put the
numbers in perspective. Among the most
important issues are the following: 1) How
atypical are these deficits compared to the
usual pattern of Federal borrowing over the
business cycle? 2) How big are the deficits in
comparison to normal savings flows from
which they are financed? 3) To what degree
are savings flows likely to respond to
the high demand for them created by large
deficits?
This Letter addresses these questions by
focusing on the supply and demand for savi ng. The evidence suggests that, despite the
projected decline in Federal budget deficits
as a percent of GN P, the deficits would continue to exert strong upward pressure on real
interest rates and to crowd out activity in
interest-sensitive sectors of the economy.
Supplies of saving
Saving is defined here net of depreciation
according to the concepts of national
income accounting. The two largest suppliers of saving are persons and businesses.
Net personal saving equals personal income
after taxes less personal consumption of
goods and services (including purchases of
durables other than housing), interest paid
by consumers to business, and personal
transfer payments to foreigners. Net
business saving is simply equal to undistributed corporate profits.
Since the 19505, net business saving as a
percent of G N P has displayed no significant
trend. It has followed a regular cyclical
pattern, rising in expansion and falling in
recession, and has equalled about 2lh percent on average. Net personal saving has
followed no particular cyclical pattern, but
is remarkable for its recent trend. After averaging nearly 5 percent of GN P in the late
1960s and reaching 6 percent in the early
1970s, it dropped to slightly over 4 percent
of GN P in 1977 and has remained at about
that percentage ever since.
It is arguable that thedecline in net personal
saving was primarily due to the rise in the
marginal tax rate for the average household,
which reduced real after-tax interest rates
and blunted the incentive to save. Indeed,
rising marginal tax rates combined with
nominal interest rates that lagged behind
inflation produced negative real alter-tax
interest rates in the last half of the 1970s.
Since then, however, real alter-tax interest
rates have risen to their highest postwar
levels, yetthe personal saving rate has failed
to rise. One is led to conclude that other
factors have been largely responsible for the
decine in the personal saving rate.
Although patterns of saving by the two
largest suppliers have depressed saving as a
percent of GN P, the total supply of saving
has actually remained relatively constant.
Total saving has received significant boosts
from its two remaining sources-state and
local government and foreign capital inflows. Since the early 1970s, state and local
government has been substantial net supplierof funds to the credit market because of
surpluses in the operation of pension funds.
In the early postwar period, these surpluses
tended to be offset by deficits on other
accounts, but as state and local government
expenditures grew in relation to G N P
(doubling between 1 948 and 1982), overall
budget surpluses came to predominate.
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of the Ft'dpral
Re'serve System.
borrowing as government expenditures
such as unemployment compensation fall
and tax receipts rise. If this were to happen in
the current economic expansion as it did in
the 1 971 -73 and the 1975-78 upturns, the
pressure on real interest rates would be
limited, and residential investment would
be able to grow over most of the cyclical
expansion. But if Federal borrowing as a
percent of G N P were to remain the same,
or even increase, as it did in the period
1 963-67, the resulting pressure on real
interest rates would produce an early
decline in residential construction.
From a balanced budget position in the late
1960s, state and local government moved to
budget surpluses of over 1 percent of GN P in
the 1970s.
In addition, foreigners have recently
become net suppliers of saving to the credit
markets. Between 1 977 and 1 978, higher
prices for oil and the U.S. economy' 5 faster
growth in comparison to other countries
combined to turn the
trade surplus into
a deficit. As a result, the international
exchange valueof the dollar fell until a sufficiently large inflow of foreign capital was
attracted to balance the
payments position. Since 1981 , high real interest rates
produced by an expanding Federal budget
deficit have combined with an anti-inflationary monetary policy to boost net capital
inflows even more. For 1983, these inflows
areexpected to reach over 1 percent of GNP.
u.s.
u.s.
In the early postwar period the Federal
government was a supplier of saving
(through budget surpluses), rather than
a demander. However, since the 1960s,
Federal borrowing has come to absorb a
growing proportion of available saving.
During the 1 975-79 expansion, the Federal
budget deficit absorbed 30 percent of net
saving, compared to 15 percent in the
1 971 -73 expansion and only 5 percent in
the 1 961 -69 expansion. Federal borrowing
conti nued to absorb 30 percent of net saving
in 1981 partly because the recovery from the
1 980 recession was incomplete. But even if
net saving were to move up to 9 percent of
GN P in the future, as business saving rebounds from a cyclical low, under current
pol icies the Federal budget deficit wou Id
still absorb over 50 percent of it between
1983 and 1986.
The total of these four sources of net saving is
shown in the uppermost line in the accompanying chart. For 1983, net capital inflows
plus state and local government surpluses
are estimated to supply an amount of saving
equal to nearly 3 percent of GNP. However,
the total supply of net saving will be no
greater than its postwar average of about
8 percent of G N P because of the recent
downward trend in personal saving and the
cyclically low business saving.
Demands for saving
Demands on the total supply of net saving
can usefully be divided into three categories
-net residential investment, net business
investment in plant and equipment and
inventories, and borrowing to finance the
Federal budget deficit-also shown in
the chart.
If the supply of saving increases in response
to higher interest rates, it may relieve some
of the upward pressure on interest rates.
But the evidence indicates that saving1s
relatively unresponsive to interest rates.
In the first place, we know that the upward
trend in Federal deficits has been accompanied by a downward trend in net private
saving and no change in the total supply of
net saving. And, second, what we know
about the various components of saving
does not suggest a large response to changes
in real interest rates either.
In business cycle expansions, net business
investment takes a growing share of the
supply of net savings, as capacity utilization
increases and inventories are restocked.
Normally, demands of the business sector
are accommodated by cyclical increases in
business saving and reductions in Federal
2
,
DEMANDS FOR SAVING'
Percent (1/ GNP
P T
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PT
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P T
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II
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*
1963 1966 ·1969 1972
1975
1978 1981 1983
1983 estimates by the Federal Reserve
Bank of San Francisco
P = Peak
T
Trough of recession
=
are certain to remain high and could well
rise even further. The level of Federal
borrowing standardized for movements
over the business cycle would remain high.
As a percent of GN P, Federal borrowing is
projected to fall only slightly faster than
in previous business cycle expansions. By
1986, when the civilian unemployment rate
is expected to be down to 7.5 percent,
Federal borrowing would still absorb 33
percent of total net saving.
Economists dispute not only the size of the
response of domestic private saving to real
interest rates but also whether the response
is positive or negative. The most widely
accepted view is that this response is positive, but not very large. My own estimate is
that domestic private saving increases 0.2
percent of G NP for everyone percentage
point increase in real after-tax short-term
interest rates because of a decline in the
demand for consumer durables other than
housing. A one percentage point increase in
real after-tax rates would bring forth new
domestic private saving equal to only 4 percent of projected Federal deficits.
Moreover, the growth of business demands
for saving is likely to be stronger than normal
for several reasons. These are: 1) accelerated shifts in the composition of thij
economy's output, which require the
creation of new production facilities,
2) accelerated shifts in the geographical
location of business, also requiring new
facilities, and 3) the spur to modernize
obsolete or otherwise inefficient or inadequate capital provided by the Economic
Recovery Tax Act of 1981. The impetus
given to business demands for saving by
these factors will reinforce the normal
tendency for real short-term interest rates to
rise in a cyclical expansion. Because of the
strength of business demands, the brunt of
the crowding out of private investment
would fall upon residential investment and,
to a lesser extent, purchases of consumer
durables.
Net capital inflows are a more responsive
soUrceof net saving but are unlikely to take a
great deal of pressure off interest rates. Over
the 1950-80period, the real after-tax commercial paper rate (on a bond equivalent
yield basis) averaged zero percent, while
the U.S. net capital outflow averaged one
quarter of 1 percent of GNP. Because real
interest rates rose sharply in 1981 and 1982,
the real after-tax commercial rate will likely
average about 2 percent for 1983, and the
net capital inflow should be about 111,percent of GN P. Using these relationships as a
benchmark, a 1 percentage point change in
real after-tax short-term interest rates would
appear to attract net foreign capital inflows
equal to nearly 1 percent of GNP.
Adrian W. Throop
However, this kind of calculation overstates
the extent to which foreign capital inflows
respond to higher real interest rates in the
longer run. Part of the current capital inflow
is temporary because it consists of a shifting
of assetswithin current portfolios. Once
these portfolio shifts have been completed,
the size of foreign capital inflows will be
diminished because they will be limited to
only a portion of current flows of foreign
saving.
The outlook
Unless the Federal government undertakes
tax and expenditure policies to reduce the
projected Federal deficits, real interest rates
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsand liabilities
large CommercialBanks
loans' (gross,adjusted)and investments"
loans (gross,adjusted) - total#
Commercial and industrial
Real estate
loans to individuals
Securities loans
U.s. Treasurysecurities*
Other securities'"
Demand deposits - total#
Demand deposits - adjusted
Savingsdeposit's- total+
Time deposits - total#
Individuals, part. & corp.
(large negotiableCD's)
WeeklyAverages
of Daily Figures
Member BankReservePosition
ExcessReserves(+ )/Defidency (-)
Borrowings
Net free reserves(+ )/Net borrowed(-)
Amount
Outstanding
10/26/83
162,213
142,168
43,209
57,347
24,919
2,790
7,537
12,507
40,305
28,670
65,783
68,453
62,803
16,978
Weekended
10/26/83
58
16
42
Changefrom
Change
year ago
from
Dollar
Percent
10/19/83
188
389
- 0.2
87
0.1
170
2,287
239
- 5.0
27
30
- 0.0
1,515
6.5
89
486
21.1
301
13.7
52
908
- 34 - 1,383 - 10.0
-1,251
1,554
4.0
2.1
599
- 876
33,967
106.8
- 403
- 31.9
504
- 32,021
- 30.4
- 27,447
506
- 54.7
- 20,502
4
Comparable
Weekended
period
10/19/83
23
o
23
125
3
122
* Excludestradmg account secuntles.
# Includes items not shown separately.
+ Includes Money Market DepositAccounts,
accounts,and NOW accounts.
Editorialcommentsmaybeaddressed
to the editor (GregoryTong)or to theauthor. ... Freecopiesof
this and other FederalReservepublicationscan beobtajnedby callingor writing the Public
Information Section,FederalReserveBank of SanFrancisco,.P.O.
Box7702,SanFrancisco94120.
Phone (415) 974-2246.
@FedFRASER