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2 Contents List of Figures List of Variables and Abbreviations Introduction Chapter 1. Stylised Facts of Saving Paragraph 1.1 Data Sets and Statistical Issues Various Saving Aggregates and Their Relationship Macroeconomic Data Sources for the U.S. and Germany Measurement Problems Saving Offshore or Saving Out of Realised Capital Gains Statistical Revisions Microeconomic Data Sources for the U.S. and Germany Paragraph 1.2 The Historic Path of Saving General Trends in the OECD Saving in the U.S. and its Various Components Saving in Germany and its Various Components Paragraph 1.3 Stylised Facts at the Macroeconomic Level Real Income Growth Real Interest Rates Inflation Unemployment and Social Security Standards Demographics... 55

3 6 T HE L IMITS OF C HOICE Inequality Institutional Environment Persistency Paragraph 1.4 Stylised Facts at the Microeconomic Level Macroeconomic Facts and Microeconomic Distributions Saving Rates in Cross-Section Current Income, Real and Relative Permanent Income The Distribution of Financial Wealth Growth, Income Fluctuations and the Role of Expectations Uncertainty and Precautionary Saving Life-Cycle Patterns of Saving Saving Motives Paragraph 1.5 Summary: Stylised Facts of Saving Chapter 2. Do Standard Models of Saving Match the Facts? Paragraph 2.1 The Standard LCPIH Basic Ideas of the Standard Approach The Modigliani-Diagram The Perfect Foresight Model in Discrete Time The Perfect Foresight Model in Continuous Time The Certainty Equivalent Model Paragraph 2.2 The Empirical Failure of the Standard Models Excess Sensitivity and Excess Smoothness Ambiguous Results MPC and Income Growth Wrong Predictions Incapability to Explain Saving Rate Differentials Paragraph 2.3 Refinements: Allowing for Precautionary Saving, Liquidity Constraints and Habit Formation Convex Marginal Utility and the Precautionary Motive

4 CONTENTS The Technique of Stochastic Dynamic Programming The Buffer-Stock Model Liquidity Constrained Consumers Models Including Habit Formation Paragraph 2.4 Do the Elaborated Models Perform Better? Gain in Realism at the Cost of Predictive Power Remaining Deficiencies Paragraph 2.5 The Optimal Consumption Path General Remarks Hidden Assumptions and Fundamental Flaws Arguments of the Utility Function Wealth as an End in Itself A Realistic Time-Horizon The Representative Consumer Per-period Consumption as a Single Entity The Elasticity of Intertemporal Substitution The Optimising Procedure Benefits and Costs Chapter 3. A New Approach to Saving Behaviour Paragraph 3.1 Basic Needs and Saving The Relative-Income Hypothesis Subsistence Consumption in Developing Countries Necessities in Developed Countries Paragraph 3.2. Basic Needs in Standard Models Introducing Good-specific Subsistence Points into a Standard Dixit-Stiglitz framework Intertemporal Optimisation with Moving Subsistence Consumption Paragraph 3.3 Modelling Saving Decisions by a Simple Rule of Thumb The Necessity Share in Outlay and in Income

5 8 T HE L IMITS OF C HOICE Determinants of Saving under the Proposed Rule of Thumb The Aggregated Saving Rate under the Given Rule of Thumb Factors Influencing the Propensity to Save and to Dissave Summary: Model Predictions Chapter 4. The Patterns of Consumption Shares Paragraph 4.1 How to Identify Basic Needs? Two Approaches to the Historic Path of the Necessity Share Basic Expenditure Groups versus Luxury Spending Paragraph 4.2 Consumption Patterns at the Macroeconomic Level Consumption Shares and Sectoral Prices in Germany Consumption Shares and Sectoral Prices in the U.S Paragraph 4.3 Consumption Patterns at the Microeconomic Level Methodological Notes Food Shelter Clothing Transportation Communication Furniture and Household Devices Health Care Entertainment and Recreation Education Restaurants and Hotels Paragraph 4.4 Summary: The Historic Path of the Necessity Share What Belongs in the Necessity Basket?

6 CONTENTS First Approach to the Necessity Share Second Approach to the Necessity Share The Individual Necessity Share Chapter 5. Does Our Model Match the Facts? Paragraph 5.1 Model Predictions and the Stylised Facts of Saving Paragraph 5.2 Model Predictions and Empirical Evidence at the Microeconomic Level The Necessity Share and German Saving Rates Reproducing U.S. Saving Rates of the Mid-20th Century Paragraph 5.3 Model Predictions and Empirical Evidence at the Macroeconomic Level Preliminary Notes Saving Rate and Basic Needs in Germany Saving Rate and Basic Needs in the U.S Is Our Model Able to Reproduce the Historic Path? Summary References

7 Paragraph 1.1 Data Sets and Statistical Issues Various Saving Aggregates and Their Relationship To scrutinise the stylised facts of saving, we review the results of the previous empirical literature about the topic at hand. In this respect, one problem deserves mention. While our goal is to uncover the determinants of saving decisions of private households, many macroeconomic studies do not explicitly refer to the personal saving rate, but to private saving, which includes saving by private enterprises. Some important and comprehensive papers even test only the relation between macroeconomic parameters and the national saving rate, which additionally contains public saving. Only few studies reflect on personal saving as such. The background of this orientation is that national statistics, especially in developing countries, often simply do not collect separate figures about personal or household saving. For that reason, the data base would seriously diminish, if analyses were limited to countries and time periods, for which reliable separate saving figures of the household sector are publicly available. Moreover, even if data are provided, the definitions and the kind of measurement of personal saving vary a good deal more from country to country than those of the broader aggregates of public and private saving. In fact, a number of grey areas, where personal and business saving is hardly distinguishable, exist. Different national statistics draw different lines, thus hindering cross-country comparisons of the data. However, household saving at least in OECD countries accounts for the major part of national saving and dominates the rate of private saving. Except for periods of rapidly rising public deficits, personal and national saving rates tend to move in the same direction and the relationship between personal saving and private saving is even stronger. Therefore, it appears reasonable to consider the findings of macroeconomic studies about private and national saving in order to inform our subject of

8 34 T HE L IMITS OF C HOICE interest: saving by private households. Debating the development of the other components of the national saving rate in detail is beyond the scope of this inquiry Macroeconomic Data Sources for the U.S. and Germany Our own calculations concern two countries exclusively: the United States and Germany. For macroeconomic data we mainly employ the U.S. National Income and Product Account (NIPA) tables provided by the National Bureau of Economic Analysis (BEA) and the German national statistics (VGR) provided by the Statistische Bundesamt (destatis). Furthermore, we refer to the Federal Reserve Board Flow of Funds statistics (FOF) and the financial flow accounts of the Deutsche Bundesbank (DB). While the NIPA data start in 1929, German data suitable for timeseries analysis are not available before 1950, detailed data about consumption shares not before The U.S. as well as the German statistics explicitly refer to personal saving or private household saving respectively. However, categorisations and the system of measurement diverge considerably. While in Germany saving has been derived from net financial wealth accumulation, in the NIPA tables saving is simply the residual between personal disposable income and consumption spending. The NIPA saving rate is calculated as the percentage of personal saving in personal disposable income. The latter includes the compensation of employees, proprietor s income, rental income, personal interest and dividend income as well as current transfer receipts. This total amount is reduced by total personal tax payments and employer as well as employee contributions to government social insurance. Saving, as mentioned, is derived by subtracting personal consumption outlay from personal disposable income. The NIPA saving rate has been repeatedly criticised, in particular the NIPA definition of disposable income. In fact, the compensation of employees as part of personal income includes not only taxes and employer contributions for government social insurance (that are subtracted to derive disposable income), but also employer contributions to employee pension funds. In contrast to the German accounting system, the latter are

9 PARAGRAPH 1.1 D ATA S ETS AND S TATISTICAL I SSUES 35 calculated as part of personal disposable income, although they are in fact not at the disposal of households. Payments from private pension funds, on the other hand, are not included in disposable income, although households certainly use them for consumption. Thus, if employer contributions to pension funds are significantly higher than pension payments, voluntary saving by households is exaggerated by the NIPA saving rate. If, in the opposite case, pension payments exceed employer contributions, the NIPA saving rate understates the real saving by households. This (measurement!) problem has contributed to the decrease in the NIPA saving rate in the nineties. Therefore, it is advisable to additionally include the Federal Reserve Board Flow of Funds statistics (FOF) in the analysis. Here, saving is not measured as a residual between income and consumption, but is derived from wealth accumulation as in the German statistics. FOF saving by households exactly corresponds to their net acquisition of financial assets plus net investment in tangible assets minus net increase in liabilities of the personal sector. Financial assets include foreign deposits, checkable deposits and currency, time and savings deposits, money market fund shares, open market papers, U.S. saving bonds, other treasury securities, agencybacked and GSE-backed securities, municipal securities, corporate and foreign bonds, corporate equities, mutual fund shares as well as net contributions to life insurances and pension funds. Tangible assets mainly correspond to residential investment. Additionally, they cover consumer durables such as automobiles and investment as well as inventories of unincorporated and farm businesses that are included in the personal sector. The main parts of liabilities are mortgages and consumer credit. Excluding consumer durables, the demarcation of NIPA and FOF saving is comparable. The levels of FOF and NIPA saving differ considerably for a number of years, particularly in the recent past. Nevertheless, the historic paths of the NIPA and the FOF saving rate between 1950 and 2010 are correlated by a coefficient of 0.91, while their yearly changes are only correlated by a coefficient of 0.47 (own calculations). Hence, regressions upon possible determinants of the level of saving will provide similar coefficients, whichever saving rate is used. In contrast, the results of regressions that use changes of the saving rate as the dependent variable strongly diverge and might be spurious.

10 36 T HE L IMITS OF C HOICE Measurement Problems Saving Offshore or Saving Out of Realised Capital Gains One has to take into account that the measured saving rate even if it is based on net acquisitions of assets and not simply grasped as a residual does not gauge all kinds of saving in the same way. A huge grey area, for instance, exists if money is shifted abroad. Although foreign deposits are reckoned in the FOF statistics, one can certainly presume that these figures are much less reliable than data about domestic saving. If saving flows are increasingly directed towards other countries, the saving rate most likely shrinks, as it does not reflect the full extent of these flows. This applies even more to those foreign investments which are motivated by the desire to remain hidden, be it for tax evasion or other reasons. But also with respect to domestic saving some activities are not adequately recorded. If, for instance, a person receives dividends and uses the money to purchase new stocks, this action is saving out of income. Yet, if the same person sells existing assets with a capital gain of equal extent and uses the gain to buy new stocks, the realised gain is neither accounted for as income nor is it reinvestment saving. From the point of view of the respective individual, both actions appear to be almost the same, but for statisticians the difference is crucial. Hence, if companies focus on pushing up their market value by repurchasing own shares rather than distributing increasing dividends, measured saving falls, although nothing fundamentally has changed in the propensity of households to save. For the same reason, saving tends to go downwards if banking accounts are increasingly replaced by stocks, since under these circumstances realised capital gains take on a more important role. This problem has also a distributional aspect. We will see later on that saving in stocks as well as realising and reinvesting capital gains is particularly typical for the very rich. Hence, the saving behaviour of the wealthiest households is most likely not adequately reflected in the aggregated saving rate. Therefore, redistributions of income and saving from the middle to the upper class might induce a fall in the measured saving rate.

11 PARAGRAPH 1.1 D ATA S ETS AND S TATISTICAL I SSUES Statistical Revisions Finally, statistical revisions taking place from time to time deserve some attention. As far as they affect the measurement of the saving rate, they obviously distort the long-run comparability of figures. For the U.S. two recent examples should be mentioned. The first is the BEA s October 1998 adjustment of the definition of personal income (directly influencing the NIPA saving rate due to its definition of saving as the residual of income not used for consumption). The revised definition excludes all mutual fund distributions from personal income and counts them as business income instead. Adjusting personal income downwards, the BEA's 1998 decision accelerated the decline of the NIPA saving rate. The second revision took place one year later. This BEA's October 1999 revision, however, had the effect of increasing personal saving first by shifting government retirement plans from the government sector to the personal sector, and second by attributing interest and dividends earned on these plans to personal income. Due to this modification, personal income appears to be higher compared to consumption. Hence, saving is pushed up. The most important revision influencing the comparability of long-run time series in Germany has been the change from the old German system, embedded in the accounting system ESA 79, to the new ESA 95 in the mid-nineties. The main difference between the two standards concerns the demarcation of the household sector. In contrast to the previous system, the economic activities of small businesses and self-employed people are included in the household sector according to ESA 95. Moreover, home purchases that previously had been accounted for as a separate sector, are now classified as an activity of private households. This enlargement of the household sector affects the measured personal saving rate in two ways: business credit and mortgages diminish net household saving, while withheld profits and checking accounts of small businesses push it up. The overall effect is not clear-cut. Employing German saving data, one has to bear in mind that the definition of household saving used by the Statistische Bundesamt deviates from the one employed by the Deutsche Bundesbank, since they deal with pension reserves of firms in a different manner. Those divergences and modifications obviously influence the long-run comparability of the data; however, they do not change the figures in a fundamental way

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