Don't Quit Your Day Job…

I apologize in advance: this post is going to be a bit heavy on theory and math.  We try to digest our statistics are much as possible here at DQYDJ, but this topic requires a bit more explanation than the average article on this site.

You see, a combination of Federal Reserve Policy and United States taxation law is literally eroding the value of your short terms funds.  Thanks to Robert Higgs at The Independent Institute for prompting this article on the expropriation of private wealth by the government.   Feel free to skip the two introduction sections below and get right to my point, or check out this WSJ article of a less wonky slant.

What is a Real Rate of Return?

To understand the real rate of return you need to understand the difference between the return of an investment and a change in price.  The concept of inflation (and deflation) mean that in the future, it will likely take more or less of a currency to acquire some good or service.  For example, a T-Shirt with a hilarious slogan might cost $15 this year, but $16.50 next year.  The price of the shirt actually ‘inflated’ 10%.  If you had invested $15 the previous year at a 5% interest rate, you made 75 cents.  Your real rate of return, if you only buy T-Shirts, was -5% – the difference between your return and the basket of goods you purchase.

The concept is exactly the same.  You can take a broad measure (like the Consumer Price Index) which calculates the change in price of a huge number of goods and compare it to your investment or savings returns to calculate your own rate of return.  So if you earn 10% on your stock investments and the CPI only increases by 3%?  Your real rate of return was 7%.

How Do Banks Determine Savings Rates?

Allow me to vastly simplify the banking system.  You know how we’ve written about using credit cards for liquidity?  Banks do the opposite of the strategy in that linked article.  You see, at it’s most basic, a bank reduces liquidity and pockets the difference in price between two levels of liquidity (short and long term).

The quote “borrow at 3%, lend at 6%” is apocryphal, but break it down when it comes to banks.  Banks ‘borrow’ money by issuing certificates of deposit and allowing people to open savings accounts.  This increases their deposits.  In theory, banking customers won’t need to access all of that money at once… so the bank can lend out money at much higher maturities (this is known as fractional reserve banking, and you better hope it works because our economy depends on it).  So a bank might have savings accounts paying 1%, and various loan products like car loans and mortgages which charge a higher interest.

One of the rates which savings accounts closely track is the Federal Reserve Primary Rate (Not the prime rate).  Large, healthy banks can borrow from the Federal Reserve at that rate – so it sets a sort of a lower bound (I know, I’m simplifying things) for the savings account rates banks will pay.  Why pay 5% when the Federal Reserve will lend at .75%?  There is no need – but banks do compete for customers, so you will still see banks which offer in the 1% range currently.  Basically, the Primary Rate is a good proxy for the savings account yield.

How Does the Government Steal Savings?

Let’s shift our focus to taxes.  As you know, the Federal Reserve is purportedly an independent institution.  The tax code, on the other hand, is completely a government function.  The way taxes work on savings is that short term gains (for example on savings accounts) are taxed on earnings – but not real earnings.

Let’s pretend your marginal tax rate is 25% and you have $100,000 in cash in a savings account yielding 10%.  You make $10,000 over a year on your money – and pay $2,500 in tax.  It doesn’t matter if inflation was running at 0% or 100% – you are taxed on the gain.

… and therein lies the problem.  Any time the Fed forces the savings yield below a 0% real yield, money that might normally be earmarked for savings accounts might be grudgingly invested in a different asset class – grandma might invest in pork belly futures instead of depositing her money at the local credit union.  People are rational – in the example above, if inflation is 10% like the yield, you are losing 2.5% a year… so why not try to find something yielding more?

On the following graph, we chart the Personal Savings Rate, the Federal Reserve Primary Rate (and the rate it replaced – and roughly meant the same thing – the discount rate), and the 12-Month CPI Change.  Roughly, whenever the blue line is below the yellow line (like it is right now) the real rate of return on a savings account is negative.

How Much is the Government Stealing?

Yeah, we know, stealing is a strong word (maybe ‘taking out of the economy’ is better?)!  We know that this policy is in effect in order to increase the increased mobility of money – to stocks and other investments or to encourage spending.  As Mr. Higgs points out, you can get a rough idea of the amount of money the government is taking with this policy by applying a rough real rate of return to the non M1 component of M2 (those are fancy names for the estimate of ‘money’ in the economy).  So, if the Fed Primary Rate is .75% let’s assume that the rate on short term funds is around 1% for simplicity.  Let’s say that the marginal tax rate averages 15%.  The 12 month inflation in October 2011 was 3.5%.  So 3.5% – .85% = a real negative return of 2.65%.  Note that the last time this ratio was negative was in the early to mid 2000s – and that culminated in a massive real estate bubble popping which is still being felt.

M2 – M1 leaves us with an estimate of $9618.8 – $2135.5 Billion in funds or $7.4833 Trillion in short term deposits economy-wide.  Through this policy – rates below inflation and taxes – the government is removing (or stealing, or taking…) $198.307 billion from the economy annually.

So… what do you think about this policy?  Do you think that this is a good thing – encouraging movement away from short term safe savings to alternative asset classes?

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