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Savings and Wealth Accumulation: Measurement, Influences and Institutions1

Edda Claus

Wilfrid Laurier University and CAMA

Iris Claus

International Monetary Fund and University of Waikato

The financial crisis and the Great Recession demonstrated, in a dramatic and unmistakable manner, how extraordinarily vulnerable are the large share of American families with very few assets to fall back on. (J. L. Yellen, 2014)2

We tend to not think about savings and wealth accumulation when times are good and incomes are rising. But when income growth stops and rainy days arrive, savings and wealth jump back to the forefront of our minds, as individuals, policy makers and researchers.

Developments over the past twenty-five years are a case in point. During the boom years of the 1990s and early 2000s, incomes grew rapidly reflecting sustained high growth rates of economic activity and an unprecedented rise in commodity prices. Furthermore, historically low interest rates in many advanced economies reduced the return on savings and lowered the cost of borrowing, contributing to higher household consumption and indebtedness and low savings rates.3 Savings rates, measured as the difference between income and consumption, have not only been low and indebtedness rising at the household level, but also at the country level, demonstrated by large and sustained current account deficits and rising debt in many advanced economies.

When the boom ended with the onset of the global financial crisis in 2007, it became clear that much of the wealth created over the previous two decades was all but on paper and individuals and countries had very few assets to fall back on. Chair Yellen's quote at the beginning of this article is applicable not only to American families but to families and governments around the world. The lack of assets has played an important part in the painfully slow economic recovery post crisis. Consumers have been hesitant about spending and high government indebtedness has raised concerns about debt sustainability. This has hindered fiscal expansions and worsened the economic downturn through a full blown sovereign debt crisis in Europe.

Moreover, many countries, some high and some medium income economies, are experiencing a demographic transition with an aging population and falling fertility rates, raising concerns about the adequacy of people's retirement savings and the sustainability of public pension funds.

It is therefore high time that we turn our attention to savings and wealth accumulation, which is the theme of this book. The nine papers presented here critically review topical issues in the recent policy and research debates ranging from the effects of access to credit, the rise of Islamic finance and sovereign wealth funds, the measurement of wealth inequality and genuine savings, the distribution of wealth across generations and retirement savings.

A fundamental principle in economics is that of utility maximization-each period people choose a bundle of consumption goods and services, including leisure, to maximize lifetime utility. The way in which people maximize lifetime utility, which represents their preferences over goods and services, is by ensuring a balance between consumption and savings during the different phases of their life. Generally people prefer stable levels of consumption to large variations, meaning that similar levels of consumption today, tomorrow and the day after are preferred to a pattern that more closely matches a person's lifetime income of no or low income when young and when retired and high earnings during working years. This desire to smooth consumption and maintain accustomed living standards typically leads to three stages of savings and wealth accumulation during the lifetime of an individual. The first stage is a period of dis-savings or borrowing in early adulthood that is marked by post-secondary education expenditures, low income and debt accumulation. The second stage is a period of savings when income is high and assets are accumulated. The third stage again is a period of dis-savings and a decline in assets during retirement when earnings are low.

Access to credit is an essential tool for consumption smoothing and the topic of the first two articles in this book. The first article by Igor Livshits (2015) reviews "Recent developments in consumer credit and default literature." Consumer credit rose sharply during the 1980s but this increase in personal debt coincided with an acceleration in bankruptcy filings in the United States and other countries with personal bankruptcy systems. The dramatic rise in household indebtedness and default raised concerns with policy makers and became a focus of attention for economists seeking to understand the driving forces behind them. Since then the quantitative literature on unsecured consumer debt and default has made great strides. In the basic model of default the key assumption is that borrowers face an interest rate that is a function of the amount borrowed and that includes a risk premium-the risk premium reflects the probability of default and is also a function of the amount borrowed. Underlying the design of bankruptcy systems is a basic tradeoff between the partial insurance of being able to walk away from debts (i.e., greater ability to smooth consumption across states of the world) and the inability to commit to repaying loans in future, which makes borrowing more expensive and reduces the scope for consumption smoothing over time. There are four possible explanations for the rise in personal bankruptcies and consumer credit. The first is increased risk exposure of borrowers: Existing borrowers face more adverse shocks. The second is increased risk exposure of lenders: Lenders advance loans to riskier borrowers. The third explanation is compositional changes in the population and the fourth is greater willingness of borrowers to file for bankruptcy. The empirical evidence reviewed by Livshits suggests that the rise in personal bankruptcies and consumer credit was due to two reinforcing factors: a decline in the cost of bankruptcy and a decline in the cost of lending as a result of interest rate deregulation and improvements in information processing technology. Moreover, welfare analysis suggests that information improvements have raised average welfare despite leading to greater bankruptcy rates. Livshits also discusses delinquency and informal default, debt restructuring and collection, and the cyclical behavior of credit and bankruptcy. He concludes with key challenges and future research directions including the need to model the interaction of borrowers with multiple lenders and combining secured and unsecured debt.

The second article by William Elliott and Melinda Lewis (2015) focuses on "Student debt effects on financial wellbeing: research and policy implications". Student debt has been rising since the mid-1980s in the United States and the authors conjecture that wealth inequality has become a more pressing problem among young adults than income inequality. Presently about 75% of young adults in the United States aged 30-40 years have higher incomes than their parents had, but only about 36% have accumulated more wealth than their parents did. A contributing factor to the lower wealth accumulation is student debt-young adults with student debt are more likely to have less wealth than their parents had despite earning higher incomes. Student debt started rising when needs based financial aid and state support for public, higher education institutions were reduced, shifting the cost of tertiary education from the government to individuals. This has had important effects on wealth accumulation. Households with student debt tend to have lower net worth and lower retirement savings than those without student debt. They also tend to have lower credit scores making it more difficult for them to gain access to productive capital to finance wealth creation, in the form of homeownership or business development. Student debt also influences other lifetime decisions. For instance, it can affect career planning (driving graduates away from lower paying, public sector jobs) and it can lower the probability of marriage and delay having children. The authors contend that schemes designed to prevent student debt burdens, such as income based repayment and pay as you earn plans, may in fact be adding to the student loan problem rather than solving it. They argue that the rebuilding of the U.S. financial aid system must begin with a more complete accounting of the true costs of student loans, both to students and to the larger economy. They also advocate for more research to be done in particular on how much debt is too much debt.

Access to credit is rising around the world including in Islamic countries and Pejman Abedifar, Shahid Ebrahim, Philip Molyneux and Amine Tarazi (2015) examine in the third article in this book the recent empirical literature on "Islamic banking and finance: recent empirical literature and directions for future research". In Islamic banking and finance the key underlying principles are the prohibition of Riba (narrowly interpreted as interest) and the adherence to other Shariá (Islamic law) requirements. A ground breaking experiment of incorporating Islamic principles into financial transactions was conducted during the 1960s in Egypt and the first Islamic financial institution with "bank" in its name was established in 1971. Since then the Islamic financial industry has developed as an alternative model of...