In this post we will examine a simple formula that reduces complex economic concepts and analysis into easy-to-understand terms. [The following is excerpted from the book, Common Cent$: A Citizen’s Survival Guide.]
Consume now or later?
These four words can help make sense of the macro-economy. First off, all economics is merely derived from simple decisions we make everyday over whether to consume something today, or save and wait to fulfill our consumption needs and desires tomorrow (or a day, a month, a year, or decade later). Think about some of these decisions you make all the time: eat at home this week so you can splurge on a 5-star restaurant meal next month; put off buying a new car or house for a few years so you can afford to get an MBA; put 15% of your income in the bank to save for a down payment on a house; or borrow to buy a car today instead of next year because the interest rates are low and the discount rebates high.
The real economy is generated by millions of these aggregated individual decisions on whether to consume now or later and the exchanges based on those decisions. The real economy can thus be represented by a simple relationship representing the trade-off between present consumption and future, or deferred, consumption. Symbolically we can represent the trade-off as:
Cpresent versus Cfuture or Cp : Cf
We might prosaically call this trade-off our inter-temporal consumption ratio (ICR), which represents all our aggregate economic decisions over whether to consume now or later.
Now, if you’re wondering where savings, investment, interest rates, government spending, taxes, etc., come in, please be patient. Just remember this simple truth: all resources and the production of goods and services are ultimately allocated toward one end: consumption. What we don’t consume today we may save and/or invest for future consumption, perhaps by our descendants, but ultimately everything is consumed. After all, “You can’t take it with you.”
We can demonstrate the relationship to interest rates and economic growth if we take the formulation and express it as a divisor:
Cf / Cp
Think about how an interest rate affects our preferences for future vs. present consumption. A high interest rate will decrease present consumption as we save more and borrow less in order to reap the high returns of the interest received. In other words, we put our money in the bank (or the money, bond, or stock markets) in order to have our wealth grow to allow us to consume more in the future. Conversely, when the interest rate is low, we prefer to consume now because there is less reward for waiting. The ratio as expressed above is positively correlated with the interest rate: if the ratio is high or rising we would expect interest rates to be high or rising and vice-versa.
This ratio is also positively correlated with the growth rate of the economy. If we defer consumption and save and invest in new production, then the economy grows and we have more to consume in the future. China has been growing at double-digit rates for the past generation because the savings rate is estimated to be near 50% of income and the population’s consumption has been deferred. Of course, China has also relied on selling their goods and services to the rest of the world, since they aren’t consuming much themselves. (Obviously, there is a limit to this “export” growth strategy since the whole world cannot simply produce and sell when nobody buys and consumes.)
Let’s try another thought problem: imagine if interest rates go to zero. Would you be a lender? A zero rate means there is no compensation for risk, zero time value of money, and little to be gained from deferring the immediate gratification of present consumption. In the extreme, a zero interest rate implies a willful disregard, or disbelief, in the future. Naturally, when interest rates go to zero, or even negative numbers in real terms,* we expect the anomaly to be short-lived. We should question the Federal Reserve’s Zero Interest Rate Policy, aka ZIRP. Their policy intent is to stimulate present consumption, but at what cost? How concerned about tomorrow are today’s policymakers?
This brings us to the point where we can discuss how different policy options might affect the ICR (Intertemporal Consumption Ratio), which will be the subject addressed in the next post, Economic Policy in a Nutshell.
* Interest rates are expressly in nominal terms, but if inflation is present, the effective real rate may be negative. For example, if the interest rate is 3% and the inflation rate is 5%, then the real rate is -2%. In this case one should borrow to the max and use the funds to buy appreciating real assets, like real estate, collectibles, or precious metals.