Tuesday, 28 September 2010

How can savings fail?

A concept I have discussed before on this blog is that it is impossible for everyone (or even just a large fraction of the population) to save at the same time. If there is an attempt to do so then the savings will perform less well than people may expect. I have come up with a story to illustrate the point. Imagine a very simple society with only two types of good, Apples and Jewels. These choices are actually surrogates for "Essential, perishable, goods" and "Non essential, non-perishable goods". There is no money, only barter. People normally only ever swap apples for jewels if they have plenty of apples spare and want the jewels simply to wear, look good and show off their status".

Let us say that the apples are grown year round. There are no fridges, so apples can only be stored for a few days before rotting.

One day the newspapers publish an (accurate) prediction that the apple crops will take a marked downturn in a few months time because of an expected weather event, perhaps el-nino or some such. Everyone will now want to "save" so that they don't go hungry. They can not store up apples because they will rot, so instead they all want to buy jewels so they can "sell" (exchange) them for apples at a later date. The jewel/apple exchange rate will rise dramatically. People will see the high jewel/apple ratio and assume that they have lots of savings. Later on the harvest fails and there is a shortage of apples. People will now be forced to start selling their jewels for apples. The jewel/apple exchange rate will plummet. The amount of apples people can buy with their jewels will be disappointing.

Here is a diagram of the situation (click on it to show full size):

Now in the real world the jewels may be a variety of savings vehicles, shares/bonds/money. Unfortunately things are complicated by the fact that the amount of money in the system is variable (due to the magic of fractional reserve banking) but one way or another, in the real world, our current savings are liable to disappoint. Either through defaults, monetary inflation or even both.

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