Jeremy Warner's Outlook: Paradox of thrift poses pensions conundrum

Icelandair/easyJet; Prudential flop

One Aspect of the pensions debate which has been widely ignored in the wake of the Turner report is what the big increase in savings thought necessary to provide us all with a decent retirement would do to the British economy in the here and now.

One Aspect of the pensions debate which has been widely ignored in the wake of the Turner report is what the big increase in savings thought necessary to provide us all with a decent retirement would do to the British economy in the here and now.

Conventional wisdom, learned from the Victorians, is that thrift is good. The more we do of it, the better. That was all stood on its head by Keynes, who argued that the greater the savings rate, the worse it can be for the economy, a theory he called "the paradox of thrift".

The theory has it that an increase in saving reduces production and employment. This supposedly occurs because a decrease in spending leads to a decrease in employment, which leads to a further decrease in spending, which leads to a further decrease in employment, and so on and so forth. Furthermore, as a result of what Keynesians call the "multiplier", an increase of intended saving may result in a decrease in actual saving. As more people decide to stop spending and start saving, demand falls, unemployment grows and before long, nobody can afford to save any longer.

But don't worry. This is not an economics lesson. These theories are important because public policy designed to increase the amount saved may paradoxically have the opposite effect. It is therefore by no means clear that the Government should be forcing people to save more. It might be quite wrong of Adair Turner, the chairman of the Pensions Commission, to be urging the Government to do so.

With the help of The Independent's Economics Correspondent, Philip Thornton, I've run some of the present day numbers on this through the meat grinder. If Keynsian theory is correct, the effect would be alarming in the extreme. The bald figures are that total pension contributions were £54bn in 2002, of which £11bn were to personal schemes and £27bn to occupational schemes. The Government paid a total of £11.4bn in tax relief in 2003/04, of which £1.1bn was to employees in personal schemes and £3.5bn to those in occupational schemes.

If people with occupational and personal pensions doubled their contributions, that would cut consumer spending by £38bn or 3.8 per cent of GDP. The Treasury would also have to pay out an extra £4.6bn in tax relief - equivalent to 1.5p on the basic rate of income tax. Another way of looking at the same problem is to assume that the savings ratio is doubled from its current exceptionally low level of 5.5 per cent of household income to its 1992 peak of 11.5 per cent. This would mean savings £46bn higher and consumer spending £46bn lower.

In new research published yesterday, Geoffrey Dicks, the chief economist at Royal Bank of Scotland, poses the question: "What if savings had stayed at the 1992 level throughout the last 11 to 12 years?" The answer is not an economically, or politically attractive one. According to Mr Dicks, consumer spending would have been 6 per cent lower by the end of the period, lowering employment by 1 per cent and pushing the unemployed claimant count above the 1 million mark.

So there are big dangers in forcing people to save more. Indeed, the way policy is now constructed, this sort of savings rate couldn't possibly be sustained anyway. Keynes forged his theories during the doom laden years of the Depression. Seventy-five years after the Great Crash of 1929 (the anniversary of which is this weekend, as it happens), the world looks a very different place. Key aspects of Keynsian theory are today an integral part of modern macroeconomic management, and the reality is that if savings crept up to a level which began to damage aggregate demand, interest rates would be cut.

People save more and borrow less when interest rates are high, thus accentuating the trough of the economic cycle. Conversely, they save less and borrow more when rates are low. The Bank of England has been edging interest rates higher in the hope of taking the steam out of the housing market. It seems to be doing the trick. Mortgage lending and house price inflation is slowing. Worryingly, the economy as a whole seems to be slowing too. Figures released yesterday show GDP rose by only 0.4 per cent in the third quarter, well down on the previous two quarters.

It would be wrong to attribute this slowdown entirely to the paradox of thrift. But what it does help to illustrate is that greater savings come at a price. Mr Dicks goes further to argue that the level of interest rates consistent with meeting the inflation target may in itself lead to insufficient savings.

Gordon Brown and his apparatchiks at the Bank of England seem self-consciously to be following another of Keynes's famous principles; look after the short term and the long term will take care of itself. Mr Turner was keen to discredit the idea of "muddling through" as a way of dealing with the pensions crisis, and of course any responsible person would have to agree with him.

My own view is that a better basic state pension, paid at a higher retirement age and funded on a pay as you go basis out of taxation is self evidently the best solution to the problem. Anything that governments do to interfere with the mechanics of the savings market is doomed to failure, and if the above analysis is correct, may even be economically harmful.

Icelandair/easyJet

Hell would freeze over, says Michael O'Leary, the chief executive of Ryanair, before he launched a takeover bid for his low-cost rival easyJet. The competition authorities might have a thing or two to say about it too. Yet from the frozen wastes of the North Atlantic comes a race that seems to be determined to take over all things British. Yesterday the Icelanders added an 8.4 per cent stake in easyJet to their shopping basket and said they might be buying more.

It's hard to believe that the buyer, Icelandair, would ever be in a position to mount a full-scale bid. Icelandair may be Iceland's largest airline, but then Iceland only has a population of 290,000, which is fewer people than easyJet carries in a week, and at less than £200m, its stock market valuation is not even a third as large as easyJet's.

None the less, with his share price close to its all-time low, easyJet's chief executive, Ray Webster, is thankful for any support he can get, and there's high praise indeed from Icelandair, which says it believes easyJet has an excellent business model and a bright future. This is a view shared by Stelios Haji-Ioannou, easyJet's founder. He thinks the shares so undervalued that every now and again he threatens to take the company private again. Iceland may be a small place, but its companies have proved shrewd investors, from Arcadia to Singer & Friedlander. The Viking descendants may be on to something here too.

Prudential flop

No such support seems likely at Prudential. Hope springs eternal in stock markets, but yesterday's flurry of bid speculation around the Pru seems so far off the mark as to be barely worth commenting on. I only do so because HBOS saw fit to put out a formal statement yesterday saying it had no intention of making an offer, nor had it even considered doing so.

HBOS has become a touch sensitive about these things after the song and dance it made about possibly bidding for Abbey National, and then failing to do so. In fact, the company is perfectly happy with prospects for organic growth, says the chief executive, James Crosby, and he wants us to forget that acquisitions were ever on the menu.

If not HBOS, it's hard to think of who else might be interested. All the other big life assurers would have problems on competition grounds, even if they could bring themselves to address the daunting challenges of integration. It looks as if Prudential investors are just going to have to grin and bear the unwanted £1bn rights issue launched this week.

jeremy.warner@independent.co.uk