Defining Income Too Narrowly

It's not clear how editorials like this one($) from the Wall Street Journal are helping the overly-indebted, savings-short, consumer culture of the current era.

At least not in the long run.

In the short run, commentary such as this probably soothes a few nerves as wage-earners work longer and harder while scurrying to and fro to collect unessential electronics goods and more nik naks to fill space in enormous homes, occasionally checking their credit limit to be sure they aren't embarrassed in the check-out line.

On the subject of a personal savings rate that plumbed new post-Great Depression lows in 2006 (-1.2 percent) after also ending 2005 in negative territory (-0.5 percent), this editorial not only misses the basic facts of the matter (two years of negative savings rate, not just one), but seeks to assuage fears that there is anything wrong.

This week's bad news is said to be the U.S. "savings rate," which according to the official measure was "negative" for a whole calendar year for the first time "since the Great Depression," as Martin Crutsinger of the Associated Press helpfully put it. Hooverville, here we come!

As a statistic, however, the official "savings rate" is nearly as useless a guide to prosperity as the trade deficit. In the government accounts, what is called the savings rate is literally income less consumption. But the government defines income too narrowly and consumption broadly. For example, "income" doesn't measure capital gains (whether realized or not), the rising value of your home, or even increases in your retirement accounts.

Think about how you calculate your own personal "savings rate." Do you merely add up what you make in salary in a year minus what you spend? Or do you sneak a peak at whether your IRA increased in value, or check the sale price your neighbor got on his home to figure out what you might be able to get for yours? By any normal definition, "savings" should include your increase in total assets -- in other words, your gains in overall wealth.

For our part, these columns long ago began to watch a far more instructive figure known as "household net worth." That number, released by the Federal Reserve, includes all assets (tangible and financial) held by individuals less their liabilities (mortgage and other debt). At the end of last year's third quarter, U.S. household net worth had climbed to $54.1 trillion. That was an increase of more than $3 trillion over the previous four quarters. Rest assured, that's a much higher figure than during "the Great Depression," AP notwithstanding.

None of this means we should be complacent about economic growth. There are two genuine clouds on the horizon -- namely, inflation risk and political risk. Inflation remains somewhat higher than is comfortable, and we still expect the Fed will consider further interest-rate hikes if today's weak dollar and soaring commodity prices lead to a jump in the official inflation indicators later this year. As for politics, the Democrats now running Congress explicitly reject the tax cuts and freer trade that have helped to propel the current prosperity. If history is any guide, sooner or later this is a recipe for trouble.

It seems that there is now an institutionalized belief by a large and influential group of economists, policy makers, and pundits that home equity and "savings" are one in the same.

In the highlighted phrase above,

By any normal definition, "savings" should include your increase in total assets...

a simple substitution yields,

By any normal definition, "savings" should include your home equity...

You don't normally see it put in these terms, but that's the message - it probably makes people feel good to realize that they've been able to "save" so much in recent years.

For most people, their home is their largest asset - in fact rising home values probably contribute to an even lower "personal savings rate" because homeowners believe that real estate is doing all the heavy lifting for them.

In the last few heady years of rising real estate prices, why would anyone cut back on spending to save another few thousand dollars a year out of their income when their home value was increasing at a rate of $50,000, $100,000, or more?

It is ironic, at the very least, that attempts to redefine a conventional measure such as the "personal savings rate" - after tax income less consumer expenditures - are the response when the result is unappealing.

But, such is the nature of money and finances in recent decades.

Whether it's inflation, the budget deficit, or the personal savings rate, when the traditional measure provides answers that you don't like, change the calculation.