Monday 18 August 2014

A Policy A Day: Variable Savings Rates

In the lead-up to the election, we are going to examine one policy per (working) day. We've selected policies to be as balanced as possible across a range of policy areas and across the political parties. The idea is to explain the background, analyse the policy to investigate the pros and cons, and give a verdict on the policy at the end. Inevitably, some opinion will make its way in and we make no apology for that - after all, we're voters too. Also, I say 'we' because this series will feature some guest posts from other young people, to share their thoughts and ideas as well. A list of all the articles is available here. Enjoy!

Today's policy comes from the Labour Party's monetary policy, re-announced on April 29, 2014, which would bring the "biggest changes to the Reserve Bank Act in its 25 year history". Two important things that the Labour Party wants to do are:
- Improve private savings by introducing universal (compulsory) KiwiSaver.
- Give the Reserve Bank a new tool in addition to the Official Cash Rate (OCR) to achieve their objectives, namely a Variable Savings Rate (VSR) that changes the compulsory KiwiSaver rate.

I say re-announced, because many of these ideas were first proposed by Michael Cullen in 2012. We owe a lot of economic progress and growth to him, but this policy needs a bit more thought. This post focuses mostly on the VSR policy, although a little discussion on compulsory Kiwisaver is provided because it affects the VSR policy. Firstly, we should have a look at what these economics/monetary terms mean in NZ. This turns out to be quite a lot, so if you're familiar with how things work, just skip ahead.

- Inflation: Things get more expensive over time, and what you can buy with $1 decreases. A lot of modern macroeconomics is based on controlling inflation, because historical examples of hyperinflation have generally led to bad things happening, and it undermines confidence in the currency because people aren't sure how much it's actually worth anymore. A little bit of inflation can be good though, because worse than hyperinflation is deflation, where people stop spending because they think their money might be worth more in the future, slowing down the economy. The Reserve Bank of New Zealand (RBNZ) is tasked with, amongst other things, trying to keep inflation between 1-3%. It does this primarily through the Official Cash Rate (OCR), explained below. The RBNZ is not a bank that normal people can have accounts with; in some ways, it is a bank for other banks to use.

- Universal KiwiSaver: New Zealand has generally had a low level of private savings, as most people tend to spend their money. KiwiSaver came into force in 2007 to encourage New Zealanders to save, by taking a contribution from their gross pay (minimum 3%), adding a matching contribution from their employer, and putting that into one of several “approved savings schemes” run by various banks and investment firms. The funds can be withdrawn (other than under certain conditions) only when the saver turns 65, locking the funds away and thus increasing the general pool of “private savings” in NZ. However, it is opt-in; Inland Revenue reports that as of March 2014, 2.3 million members are enrolled, contributing around $3.2 billion a year into a total pool of $18.2 billion. As superannuation continues to rise in cost and become an unmanageable burden on the government, the Labour Party wants to make the scheme compulsory for everyone, while increasing the minimum contribution rate to 7% over a few years.

- Official Cash Rate: The majority of banks in NZ have a settlement account with the RBNZ, which allows the banks to settle their financial obligations to each other easily at the end of each day. Practically, this ends up meaning that sometimes banks have positive (deposit) balances with the RBNZ, and sometimes owe the RBNZ money. The interest rate that the RBNZ pays on positive balances or charges on negative balances is related to the Official Cash Rate (OCR). The banks then pass that revenue/cost onto their customers, for example by paying interest on savings accounts and charging interest on home loans, while taking a cut for themselves in each direction. The RBNZ reviews the OCR every six weeks to react to a variety of changes, from changes in our exchange rate to changes in our current balance, all with the ultimate goal of keeping inflation between 1-3%. This does come at the cost of limiting the growth of the economy as well.

So how does all this work? A central theoretical concept in managing economies is to keep money moving. If we keep money moving, then it's being spent and invested and spent and invested and the economy as a whole grows. But if this keeps happening without control, then inflation would grow very quickly. A centrally controlled interest rate is meant to encourage savings and discourage borrowing at certain times when the economy is doing well and we need to reign in inflation, and discourage savings and encourage borrowing at others when the economy needs a boost and we can risk letting inflation rise for a bit. This is essentially what the OCR does; the general case is that when we need to keep inflation within the acceptable limit, the OCR is increased, people save more and spend less, and as a result inflation doesn't rise quite as quickly (but neither does the economy). The opposite generally only happens when there is an economic downturn, such as during the recovery after the Global Financial Crisis (but then it happens very quickly). See the below graph - note how the OCR is (generally) increasing up until the GFC hits in 2008.

So this is how the RBNZ has operated for 25 years, with only a few changes to the inflation target. However, the OCR is often called a "blunt tool", meaning that it is not a very precise way in controlling inflation. If changing the OCR causes an overcorrection one way, forcing the RBNZ to change the OCR the other way causing another overcorrection, then it is not a very good tool. Additionally, changing the OCR tends to have a lot of other side effects; for example, our relatively high OCR (in comparison to other countries) means that our currency is very valuable, causing the exchange rate to increase (hence the calls of an overvalued NZD), making life more difficult for our exporters as their profits are eroded away.

Analysis of the Policy
Labour is therefore potentially doing the right thing in trying to find some other tools that can be used to control inflation. The central concept behind Labour's policy is to have better control over private savings, which essentially remove money from the economy by reducing spending, thus influencing the interest rate. The first step is to make KiwiSaver compulsory, so that everyone is invested in this system and cares about what happens to their savings. It increases the size of private savings, but more importantly it also increases the effect of changes to the saving rate, which plays into the second step. 

The second step is to introduce the Variable Savings Rate (VSR), which changes the rate that people contribute to their KiwiSaver accounts. As stated above, the current minimum rate is 3%, but whatever rate you sign up for, that rate is constant over time (until you change it, but that's in your control). A VSR would become another tool that the RBNZ can use to control inflation, with a different set of side effects.

For example, the OCR has a large impact on interest rates for home loans. At the moment, if the OCR increases, then home loan rates also increase. This means that NZers (and their obsession with property) end up paying more on their debt. This achieves the purposes of raising the OCR in that people have less disposable income, and thus dampens inflation. A downside is that the profits from these increases generally don't stay in New Zealand, because most of our major banks (ANZ National, Westpac, ASB, etc.) are owned by Australian parent companies, so the profits go offshore. The VSR could allow for the same amount of money to be "removed" from the spending economy, but instead of sending the money overseas, the money goes into your retirement fund and you get it back later. You can't spend the money now (so it dampens inflation now), but the money remains "yours".

On the flipside, raising the VSR means that people get less money in their bank account now, because more money is taken out of their paycheck. In the above example, only those with home loans or with debt have to pay more as a result of an increased OCR. Everyone else generally benefits from the increased interest on their savings in the bank. Raising the VSR takes more money from everyone, removing some choice and financial independence of individuals, so that they can't choose whether they'd like to put their money into buying a home or put their money into their retirement (or spend their money on something else entirely different).

There are a number of things the VSR would help with, beyond keeping inflation rates in check. As described by Jono Natusch here, it would also help keep our exchange rate in check by leaving interest rates lower (similar to the OCR), it would improve New Zealand's poor savings record, and it helps make our current account more positive by keeping more money in New Zealand (rather than sending it overseas via the banks). That last effect is significant, because it appeals to our nationalistic and patriotic nature (although if that nature was strong enough, we'd all be KiwiBank customers by now). Making the VSR a tool that the RBNZ can use also maintains the RBNZ's independence from politicians (as much as possible), and would make it harder for politicians to play political football with people's savings.

One fundamental problem exists when discussing the OCR and VSR. The idea is that the VSR can achieve the same function as the OCR (and we're not saying that one would replace the other entirely, the two would be used conjunctionally to achieve an overall effect), and together they would respond to changes to control inflation in the same way that just the OCR by itself does now. It is therefore important to look at how much VSR has to change to achieve the same effect as the OCR, and here lies the issue. The OCR affects a larger pool of money than VSR - OCR affects all savings and all debts, VSR only affects income. To achieve the same effect as increasing the OCR by 1%, the VSR would have to increase by much more than 1%. Steven Joyce (National Party) says that a 1% increase in OCR would take about $2.5 billion/year out of the economy, while a 1% increase in VSR would take about $400 million/year (disclaimer: David Parker of Labour disputes these numbers). Westpac economists estimate that to achieve the same effect as increasing the OCR by 1%, the VSR would have to increase by 6-10%. This is a huge difference - previously the RBNZ might increase the OCR by 1%, costing people 1% more on their homes and other debts, but if they increased the VSR by 6% to achieve the same effect, it would cost people 6% of their paychecks. VSR also affects a much wider pool of people; a relative minority each owe a lot of money in home loans each year, but a relative majority each earn less money in income each year.

Additionally, it introduces more uncertainty for individuals. As far as home loans go, people can take fixed or floating home loans. Fixed gives individuals certainty in their financial planning, because they can predict and can calculate how much they need to pay every cycle to meet their debt obligations. A floating one is less certain, as it is at the whim of the OCR, and the interest rate can go up and down over time - but at least people have the choice and agree to take on the risk and uncertainty of a floating home loan. A VSR gives people all the uncertainty with none of the choice - depending on how often the VSR is adjusted, you could take $1000 home one week, and $900 the next week if the VSR goes up. Suddenly saving up for a holiday or paying the bills becomes a lot harder to plan. In the short term, it would feel like a new tax for most people, as they see less of their paycheck. It also has a larger effect on low and middle income earners who are already struggling to survive with their existing income levels. A VSR doesn't even advantage home loaners over an OCR significantly - even if the interest rate on their house doesn't increase by as much (saving them money in the repayment costs), the money taken out of their pay would offset most of that. The costs of compliance would also be difficult for employers as their contribution may float with the VSR as well (which disproportionately affects small businesses), but also because most accounting software is badly designed and the costs of changing things like tax rates and KiwiSaver contribution rates is actually non-negligible.

There's also a very long-term effect that has been mostly ignored - when people get their money back! At the moment, with OCR increases when the money is "removed" from the economy generally either the banks lend it out to others or the profits go overseas and out of the country. With the VSR, while people can't spend the money now (keeping inflation down now), people turn 65 eventually and they'll get all the money back at once. What's going to happen at that point - will they keep saving the money? Probably not, they're much more likely to go spend it, driving up inflation. So the VSR policy in a way just delays the problem, even though it is near-impossible to predict what the economic situation will be in 10, 20, or 30 years time (in terms of economics, "let's deal with that problem later" may be a legitimate strategy). There's another worry here too - David Parker says that "nowhere currently" uses a VSR system, so there is little empirical evidence to show that this system would work. It'd be nice to find some (country-sized) guinea pigs.

Finally, we should consider whether compulsory KiwiSaver would actually increase savings in the long-run, and there is a lot of evidence to suggest that this is not actually the case. Why? People who really want to buy things will do so. If we take the money out of their paycheck and put it into their KiwiSave now, then they'll dip into their own savings or go into debt to get it (whether that's via a personal loan, credit card, or other). This is a relatively contentious point because different people act in different ways, and there is probably insufficient evidence to make a strong claim either way, but analysis in Australia (where they have a compulsory savings scheme) as well as by our own Treasury suggest that these schemes may in fact reduce national savings overall.

Verdict: Compulsory KiwiSaver and VSR are interesting "outside-of-the-box" ideas in an area that really needs some good ideas, but unfortunately come at a higher cost than the benefit they would bring.

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