Financial Advice from the Fed Chair

In two recent speeches Federal Reserve Chairman Janet Yellen has highlighted issues of personal finance. In each case she referred to results from the Fed’s triennial Survey of Consumer Finances (SCF), the most recent version of which (2013) was released just last month. In September, Chairman Yellen commented on the meager levels of wealth for families in the bottom quintile of the wealth distribution. The average net worth reported by the bottom fifth was just $6,400 in 2013. The next fifth had median net worth of $27,900. She commented on the importance of having a financial cushion to absorb shocks, and the benefits of asset building more generally. In October, the Chairman gave a lengthier speech on trends in income and wealth inequality. Again referring to the 2013 SCF, she noted that the top 5% richest families owned over 60% of total wealth in 2013, as compared to just over 50% in 1989. This is due to people at the top doing really well and most of the rest just treading water. The Chairman appears to be extremely concerned with these trends, particularly inasmuch as they suggest declining economic opportunity.

In the October speech, Chairman Yellen goes on to discuss four means by which economic opportunity can be enhanced. The first of these is greater pre-school and K-12 funding for poor neighborhoods. She suggests that funding public schools through the property tax naturally leads to highly unequal resource availability across communities. The second means to achieve greater upward mobility is availability of affordable higher education. Thirdly, she points out that business ownership has long been a part of the American dream and is a source of wealth enhancement (at least, for the 10% or so of start-ups that do not fail). She notes a downward trend in the rate of business ownership as reported by the SCF. She does not speculate on reasons why it has become harder to start and build businesses in America. Finally, the Chairman mentions the role of inheritance in helping improve families’ financial situations. I find inclusion of inheritance surprising in this context. Certainly, it would be great for a poor family to receive a large inheritance, but that must be very rare for low wealth households.

I think the Chairman could usefully combine her two speeches and by doing so come up with a fifth source of upward mobility, namely, save more. The essence of the September speech was the importance of building up assets. I take that to mean that Chairman Yellen is in favor of higher savings rates.

It is interesting to ponder what levels of savings the Chairman would consider appropriate. For example, would the Chairman be content if everyone got religion and the savings rate immediately jumped substantially, say, up 10 or 20 percentage points? The patron saint of Keynesian economists, Lord Keynes himself, described a situation wherein higher rates of intended savings backfired. In this situation, the so-called “Paradox of Thrift,” higher savings rates result in lower aggregate demand and equilibrium income, so that the amount of savings is lower even though the rate is higher. Assuming Chairman Yellen is a good Keynesian, I wonder if she would be comfortable in promoting large savings rate increases.

Anyway, while broad-based substantial increases in the savings rate are almost surely not in the cards, it is interesting to speculate about what could be accomplished at the household level by healthier savings. My colleague Richard Stern and I have developed software (FINSIM1.0) that estimates the probability of reaching various financial goals including wealth building and retirement spending. Consider the median income family, with income around $50,000. Let’s assume this family is also the median wealth family, with financial wealth of $75,000. Finally, assume the family follows the advice of consumer advocate Senator Elizabeth Warren and saves 20 percent of income. FINSIM runs show that this family is likely to move well up the wealth distribution. Over the remaining lifetime of the household head (currently aged 40), and assuming a 50/50 investment allocation to stocks and bonds, a 6% expected real return on stocks and a 0% real return on bonds, we estimate a one in two chance of moving from the 50th percentile of the wealth distribution to the 75th percentile, a one in three chance of moving up to the 90th percentile ($1 million net worth in real terms), and a 1 in 10 chance of moving up to the 95% percentile ($2 million net worth).

If we take the median college graduate (that is, the college graduate with median income and zero wealth), the chances of moving up the wealth distribution are even greater. Bottom line, there is a lot of upside potential.

Of course there are important reasons why people are not saving. One reason is sluggish wage growth in recent years combined with lots of exciting new products to buy (the latest smart phone, your own 3-D printer, etc.). And a second reason is simply that current interest rates are really low. In fact, the real after-tax return on “safe” money market or deposit products is negative (maybe Chairman Yellen is in a position to do something about this). Why defer enjoyable consumption when the rate of return is less than zero? In our simulations, as noted above, we assume 50/50 allocation to stocks and bonds, with a six percent expected real return to stocks and a zero real return to bonds. Effectively, we are assuming an expected real return of 3% and return volatility of 10%. You will not earn a positive real return if you are unwilling to take stock market or other risky asset exposure. To get ahead, you have to take some risk as well as defer consumption.

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