Compulsory saving has been raised as a solution to New Zealand’s perceived saving problem.   Last week my colleague discussed how compulsory saving is a blunt tool for solving any perceived failure in credit markets.   This is an important point, one that I wish to expand upon this week.

To start with, let’s ask why compulsory saving is really an indirect solution.   Normally when individuals look at problem at the aggregate level we will try to bring it back down to the individual level we want to personalise a situation so we can apply our own common sense.   However, when it comes to looking at the aggregate economy this sort of logic doesn’t always work.

If a person is borrowing "too much" of their income, the solution seems simple enough they need to save more.   However, when looking at an entire economy, the level of income and how much is spent and invested are positively related.   Funds borrowed are used for spending and investment, and so a country that is borrowing may be increasing its level of income.   By forcing people to save, and thereby reducing their ability to borrow, such a policy could ultimately reduce incomes.

Furthermore, when looking at the economy rather than an individual it is a lot harder to decide how much debt is too much.   An economy is made up of a large number of very different people some who value the ability to borrow now highly, and others who do not wish to borrow.   As a result, attitudes and beliefs regarding debt differ between individuals and it isn’t clear why we should restrict people’s ability to borrow (from a willing lender) just because some other third party doesn’t like the idea of it.

Simply stating that our net debt level is too high, and telling everyone in the economy they have to save more, ignores these complications and has the potential to lead to worse outcomes.

So if compulsory saving isn’t the solution, what should we be doing?

If, as a nation, we look at the fact that New Zealand has a net liability to the rest of the world of 89% of its annual income (GDP), and feel that this is too high we need to try and understand why this level of debt appeared, and tailor our solutions based on this understanding.

Who has borrowed?   What have they done with this debt?   These are the two primary questions we need to ask in order to understand New Zealand’s net debt position and what potential issues there might be.

As a rough starting point, we can look at the sectoral claims data from the Reserve Bank.   According to this data, the debt held by households relative to the debt held by enterprises rose from 97% in June 1998 to 129% in June 2010.   This increase suggests that households bear more responsibility for the rising debt level than the rest of the economy.

But what exactly have households done with this debt?   In order to get an idea of this we can look at nominal GDP.

The share of GDP spent on consumption stayed close to its 1988-2010 average throughout the last decade.   So although the level of spending on consumer goods may be related to the level of debt, it has not driven the acceleration in debt accumulation that occurred throughout much of the last decade.

However, residential construction as percentage of GDP did rise significantly above its trend between 2004 and 2008.  So if anything, a cursory look at the figures suggests that New Zealand households invested a bit much in new property in recent years.   This outcome may have been the result of the favourable tax treatment of property relative to their investments and/or other potential biases that existed in the industry.

If this choice created costs for society more generally, the government should introduce policies to deal with the distortions directly.   In the case of housing, the government has made changes to the tax treatment of property in order to try and clear up this “misallocation" of investment.   If this distortion was the only one, then New Zealand’s debt position should now improve over time, and there is no need for further savings related policies.

This issue deserves a much more in-depth analysis then the quick look over the statistics I have provided here.   It requires time looking over the data and trying to understand where there is a distortion in the market, either resulting from market or government policy failure.   Then any savings policies that are introduced should be based on our analysis of these distortions not on the eagerness of fund managers to receive funds from compulsory savings schemes.