Don't mortgage the future to save the present

At the core of the recent financial mess is a simple fact: Americans consume too much and save too little. Barack Obama, in a policy speech given in the battleground state of Ohio, outlined a plan permitting withdrawals from IRAs or 401(k)s without penalty. These withdrawals divert savings to consumption. Changing the withdrawal penalty incentivizes Americans to increase consumption and decrease savings. These changes make it more difficult for the American economy to return to health. Instead, Senator Obama should have proposed an expansion of loans against retirement accounts.

Senator Obama’s stated intentions are reasonable: to ensure families are not “being forced to make painful choices like selling their homes or not sending their kids to college.” There are two objections to this line of reasoning.

First, the plan overlooks existing safeguards in retirement plans. Families can tap IRAs to fund college, buy a home for the first time, pay medical expenses, purchase health insurance, or in the event of death or disability. 401(k)s allow loans against the account balance. While there are circumstances – like inability to pay mortgages – where Obama’s plan will help, one must also consider the possibility that individuals will use retirement accounts like many used their homes: as ATMs to fund personal consumption.

The second objection is that this withdrawal is bad for both individuals and the overall economy. Withdrawing funds is negative savings; these withdrawals allow individuals to consume more now, at the expense of not being able to consume as much in the future. Unfortunately, Americans do not save enough for retirement as is. Allowing individuals to deplete retirement savings is trading relief from an asset bubble/credit crisis today for a retirement savings crisis in the future.

Mr. Obama’s proposal also exacerbates the inadequate savings that plague the U.S. economy. For twenty-five years the U.S. savings rate has been declining and it is far below the savings rate of other countries. Saving is important because it drives investment in the economy which directly affects American productivity. The U.S. has overcome our low savings rate by investing too little in infrastructure and borrowing from other nations to fund investments. As saving declines, the economy can adjust through two unattractive options: further reduction in investments or increased borrowing from abroad.

Senator Obama recognizes the need for increased savings in the speech that outlined his new relief proposals:

“We’ve lived through an era of easy money, in which we were allowed and even encouraged to spend without limits; to borrow instead of save.

Now, I know that in an age of declining wages and skyrocketing costs, for many folks this was not a choice but a necessity. People have been forced to turn to credit cards and home equity loans to keep up, just like our government has borrowed from China and other creditors to help pay its bills.

But we now know how dangerous that can be. Once we get past the present emergency, which requires immediate new investments, we have to break that cycle of debt. Our long-term future requires that we do what’s necessary to scale down our deficits, grow wages and encourage personal savings again.

The senator’s understanding of economics appears sound; the immediate injection of funds is almost Keynesian and the longer-term need to increase savings is acknowledged by both sides of the aisle. However, substantial discipline is required to switch from increased consumption to increased savings. To ensure that savings eventually increase, Mr. Obama should modify his proposal to allow loans from retirement accounts instead of outright withdrawals.

By utilizing loans the proposal would provide the relief sought by the senator while creating a mechanism to increase future savings via loan repayment. Individuals who borrowed from retirement accounts would be required to contribute money back to retirement savings or face punitive taxes. Borrowers would be incentivized to save.

An example: an individual utilizes the withdrawal plan outlined by Mr. Obama. The crisis passes and the individual again commands disposable income, and considers two options: save $1000 for retirement or purchase a $1000 TV. The cost to acquire the TV is simply the $1000 list price. If one had taken on a loan as outlined above, one would face a different decision. Either save $1000 for retirement or purchase the TV plus pay a punitive tax, raising the effective cost of the TV to, say, $1400. In this scenario, the consumer is highly motivated to save to avoid an additional $400 in taxes.

Setting appropriate tax rates and interest rates would permit the government to encourage substantial savings by individuals. This modified approach to Obama’s plan would ease short-term economic strains without harming the long-term economic health of the nation.