Today we're going to try to pin down a definition of savings.
The issue of the declining savings rate in America has been mentioned as one of the ways in which the younger generations are falling behind economically. The credit crisis caused massive deleveraging in America which increased the savings rate, but most of it was due to consumers reducing debts and liabilities as opposed to building assets. There could be many causes of this, but to name one: in times of uncertainty, consumer tend to brace themselves for a more hazy future by building net worth as quickly as possible. A decrease in stock prices and home prices eliminated much of the buildup of household assets which needed to be counteracted by an increase in savings. Also, credit standards have tightened, which has further compounded the problem and increased the deleveraging among American households.
The Difference Between Stock and Flow
What exactly is 'savings'?
The point of this article, however, is to argue how one should calculate the savings rate. The difference between a stock and a flow is important to understand to determine your savings rate. A 'stock' is an amount at a given point in time; think of terms such as net worth, assets, liabilities, debts. A 'flow' is a time-sensitive change; think of terms such as income, expenses, appreciation, cash flow. Savings to me (similar to PK’s definition) are meant to maintain principal and (hopefully) appreciate over time. In this way, saving is an attempt to help future cash flows. Appreciation of assets is not considered savings, since, in the opposite example, you can put away $50k in a year and have your stocks decrease by $50k. Did you save $0 that year?
Savings is any way in which you increase your net worth. Since your net worth is simply the difference between your assets and liabilities, there is no difference in this definition between paying down debt and building up assets. When you make a mortgage payment your 'expenses' are the mortgage interest, insurance and property taxes. The principal payment are instead considered 'savings', since it goes directly toward increasing your net worth (less debt). As mentioned above, saving should help increase future cash flows. Buying an asset which appreciates in value positively affects those future cash flows. Paying down debt decreases future interest payments which also helps cash flow!
Savings and Net Worth Increases - and the Definition of Savings
So, does paying down $3,000 in credit card debt count as saving? Yes, of course. When the balance was first built up, the card’s user was effectively using a negative savings rate. If in 2011 you added $10,000 to a retirement account, paid down $10,000 on your mortgage and saved $10,000 in mortgage bonds... congratulations, you saved $30,000 last year.
Compare your savings rate when calculated using PK’s definition of savings versus mine. Which do you feel is more accurate?
