Spike in household savings rate only temporary
Recent data from Statistics Canada provide insight into the economic behaviour of Canadians during the COVID-19 outbreak. On August 28, StatsCan reported household savings rates for the first and second quarter of 2020, with historic results.
In the first quarter of 2020, Canadians saved 7.6 per cent of disposable income, which was the highest rate since 1996. However, the second quarter saw a spike to 28.2 per cent, the highest savings rate since at least 1961. To put this figure in context, the average rate over the five years preceding COVID was about 3 per cent.
In normal times, an increase in household savings might be considered a good thing, as higher household savings has been associated with higher levels of entrepreneurship and other benefits. Obviously these are not normal times, so what should we make of the spike in Canada’s household savings?
Economic theory provides some insight. The late Nobel prize-winning economist Milton Friedman developed a concept known as the Permanent Income Hypothesis (PIH) to analyze consumer behaviour. Supported by empirical data, Friedman’s research suggests that people tend to consume in line with what they expect will be their permanent income. In other words, people tend not to treat temporary changes in income the same way as they do permanent changes (i.e. they save the bulk of their transitory income).
The permanent income hypothesis asserts that temporary increases in income will lead to minimal increases in consumption because people understand the temporal nature of the increase in income. Permanent increases in income, however, are likely to lead to larger increases in consumption because people place higher probabilities on sustaining the greater income level in the future.
This finding has implications for Canada’s current savings rates as well as temporary income programs such as the Canada Emergency Response Benefit (CERB). Friedman’s work suggests that a temporary spike in income is more likely to be saved than spent, as people anticipate that higher government spending today is financed through higher taxes in the future, and because they recognize the temporary nature of the income. As such, the savings rate in Canada has likely spiked because Canadians are depositing temporary payments from the CERB (and similar programs) into savings accounts at their banks rather than spending all of the money, because permanent income for the individual remains unchanged.
Finally, historical research from the Bank of Canada suggests that Canadians may be reacting to the rapid deterioration of government finances. Their analysis examining Canada’s long-term trends in personal savings found that the fiscal balances of government are one of the most important determinants of personal savings. Put differently, Canadians save more when they are worried about the government’s fiscal direction. People also tend to save more out of precaution at times of high uncertainty over their own prospects. This is consistent with Friedman’s theory that in periods of severe economic contraction, a greater share of income is seen as transitory rather than permanent.
Canadians have been saving at unprecedented rates in the first half of 2020. Research tells us that this behaviour may be explained by a spike in temporary income measures such as CERB, as well as increased concern over the country’s future fiscal and economic prospects. For governments considering policy changes in the months to come, it will be important to remember that the recent spike in savings is only temporary and we must look to improve long-term economic and fiscal conditions to meaningfully improve the quality of life for Canadians.