The ECB once again decided to postpone the end of the era of cheap money in the Eurozone and leave the benchmark interest rate at zero. The North, unsurprisingly, is not impressed. Northern European economists and politicians alike bemoan the interest rates, not only because of their supposed adverse effects on the discipline of Southern European Euro member states, but also because of the savers’ continued suffering from the low interest rates. With every percentage point that interest rates drop, economists lament, European savers lose tens of billions of euros per year. At the same time, corporations make billions and the stock markets keep hitting new record highs. Why are European savers not profiting from that?
Europeans love security
In Europe, people traditionally have large amounts of cash and invest in portfolios comprised of low-risk securities and life insurance. By contrast, in the United States they tend to invest a larger share of their savings in riskier, but on average much more profitable securities, that is equities (mostly shares of listed corporations) and corporate bonds.
There are several possible explanations for this difference in investment behavior. On the one hand, Europeans might just be less entrepreneurial, more risk-averse and wary of the capital markets, which are viewed as both a complex and dangerous endeavor, and as a playing ground for greedy gamblers that people do not want to be associated with. On the other hand, there are fewer incentives for the average European to put a lot of thought into how to profitably invest their money. Governments in most EU member states are largely taking care of some of the major reasons to save and invest in the United States: pensions, university tuition, and healthcare. With “Pay As You Go” schemes dominating in the European Union, where both payments and disbursements in case of need are fixed, citizens do not have to worry about the hassles of long-term investment plans, of stock-selection and diversification. They are happy if their money stays safely where they left it: under the virtual pillows of government-guaranteed savings accounts.
Financial theory tells us that the market rewards taking higher risk with higher average returns. Indeed, while interest rates on bank accounts and top-rated government bonds have crumbled after the Financial Crisis, the stock and corporate bond markets offered some profitable investment opportunities, in Europe as well as abroad. European and American stocks within the last five years earned gross annual returns of 4.6 to 14 percent, as measured by the MSCI indices which are designed to capture 85% of the markets for large and medium-sized equities in the respective countries.
Gross average annualized returns on stocks across countries in percent as per 08/2017
* 1998 for France, Spain and Italy, 1994 for the others, Source: msci.com
Of course, investing in stocks is not a suitable way for non-professionals to make money quickly. It is a risk that is not guaranteed to pay off after just a couple of years. The stock market crashes of the Dotcom-Bubble of the early 2000s and the 2007 Financial Crisis are the most prominent recent examples of how equity-laden portfolios have lost a large share of their value within a very short amount of time. Nevertheless, it is a risk worth taking for people who are saving for long-term goals, such as their pension or their children’s education. Portfolios comprised largely of equities have been shown to outperform their more secure counterparts in many studies over long-time horizons and that is where even small differences in average returns have tremendous effects.
Better access to finance for businesses
Financial intermediaries such as banks and insurance companies keeping a share of the returns on people’s investments and spending it on their (very well-paid) employees and overhead cost might be annoying for the individual. But does it matter for the economy as a whole that it is them who manages our money? Depositors and insurees are the main investors of banks and insurance companies, which are lending it to and investing it in companies. So, whether it is them or us, should the money not find its way into the businesses that need it anyway?
Well, yes and no. While it is true that these institutions are investing the funds that they are entrusted with in the economy, they are highly regulated businesses. Laws restrict them in terms of how much money they are allowed to invest in assets that are deemed as risky, and how much they have to invest in less profitable but more secure alternatives. Regulations following the Financial Crisis, most importantly the Basel Accords, made these rules even stricter. Government bonds are the most prominent example of assets that are seen as very secure, making them a very demanded investment target for banks. This, in turn, diverts the funds away from the private sector. But even beyond those, regulations give banks an incentive to focus on large, well-known corporations rather than small and medium-sized businesses. While these enterprises might offer more promising investment opportunities, they also have higher default risks and would require for banks to set aside larger amounts of precious equity. As a result, artificially high demand causes interest on government bonds and “safe” corporate debt to be low, while smaller businesses have difficulties acquiring the funds they need at reasonable rates.
This is not to say that over-regulation of banks is the problem. There are several lessons we learned from the Financial Crisis, for example that risks can be underestimated on a systematic level on the financial market, that the collapse of individual financial institutions can have fatal consequences for the entire world economy, and that depositors are not equal to investors. They see banks as service providers, they do not treat their bank accounts as investments, they cannot be expected to evaluate different alternative banks based on the risks they might hide in their balance sheets, and hence, they need regulatory protection. However, they can be expected to educate themselves when it comes to investing their own money, decide for themselves what risks they are prepared to take and what returns they are aiming at over what period of time, so that is what we should focus on.
Better prospects for our future elderly
If we look into the future, more problems with the European investment behavior become apparent. The continent is aging but most pension systems here are the so-called “Pay As You Go” plans. That means, that what is being paid out right now is being raised simultaneously through taxes and contributions. No assets are set aside to finance future payments; the value of claims that the current generation is building up depends completely on the future generation’s ability to settle them. Because of the demographic change, the number of workers per retiree will decrease drastically in the coming decades. The burden of that will have to be shared by future pensioners and tax-payers. Because of the sheer size of the problem in some countries, those with a particularly unfavorable age distribution will have a competitive disadvantage: if governments decide to increase labor income taxes, the young and well-educated may leave and work in younger countries; if capital income taxes are increased instead, investments will be moved abroad, making the situation even worse.
All this could be mitigated if people started to shift their money from deposits and low-yield savings schemes to shares and corporate bonds for two reasons. First, the additional income would alleviate the pressure on governments to increase contributions. Second, a well-diversified portfolio of claims against corporations might turn out to be a better insurance than one comprised of assets that are ultimately backed up by sovereign bonds which are guaranteed by governments facing increasing financial pressure from exuberant debt obligations. If we invest in corporations abroad, in younger, high-growth economies, they will have to pay for our pensions in the future; if we invest in our own, we as their investors get a share of their profits even in case they decide to move abroad.
Improving wealth equality
The richer the people, the better the investment decisions they tend to make when it comes to long-term profitability. While they buy shares, poorer people tend to prefer deposits, gold and insurance. This way, the rise in wealth inequality that we observe everywhere in the Western World is accelerated, since the larger savings of high-wealth individuals also yield higher average returns.
Now, part of this is inevitable: poorer people need for a larger share of their savings to be liquid in case of unforeseeable expenses and therefore cannot invest them into risky assets that could happen to be in a plunge in a time of need. But to the extent that also the poor’s long-term investments are doing worse, this has to be explained by other factors, such as lower financial literacy or limited access to investment consulting. Policies that are aimed at reducing wealth inequality should focus on identifying these factors and improve wealth accumulation at the bottom rather than focusing solely on trying to decelerate it at the top.
How to move forward
Learning how to invest our money from our friends across the pond means to make the best out of our savings, to make our capital markets work so that business get the financing they need, to provide a more sustainable safety net for our elderly, and even, as hard to believe as that may sound, to improve equality. There are several conceivable ways to achieve this. Different policies are and have been debated and partly implemented, such as tax incentives, capital market deregulations, and government-subsidized savings schemes. Some of the steps that have been taken in the past, such as the subsidized pension savings plans introduced in Germany under the Schröder government, have faced some criticism lately because of their perceived opacity, overregulation, and hidden costs. Evaluating which policies exactly are the best ones to achieve the objective of widespread capital formation will take some work. Maybe we have to start lower first, by spreading awareness that we are missing out, that learning how to take proper care of our savings, as dull and annoying as it may seem, matters.
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