Why Economic Models Fail

The main reason I do not put any faith in modern economic theory is because it removes the human variable from the equation. In a free market, different economies will have different characteristics and behavior patterns due to structural and cultural differences. A case in point is the savings rate in the U.S. and China. Michael Pettis explains:
Rising interest rates increase the reward, and so in response, households reduce their consumption and increase their savings. The obverse is that the interest rate is the penalty for anticipating consumption, and because rising interest rates make it costlier to borrow to finance consumption, they reduce consumption and increase savings (borrowing is negative savings).

This explanation for the positive relationship between the interest rate and savings rate makes it a little surprising, then, that in China and in certain other countries, especially those typically included as examples of the Asian development model, rising interest rates are often associated with higher, not lower, consumption.

...Last year, just after the PBoC cut the deposit rate early in the year, one of my students told the class an interesting story that may at least partly explain. She said that the reduction in the deposit rate had upset her aunt and uncle because they had been saving money so as to have a certain amount for their twelve-year-old son for his university education. Every month his mother put some part of the family’s household wages into an account at the bank for that purpose.

How much should she save?

Obviously she had done a fairly straightforward calculation to figure out how much she needed to add to this account every month. The amount of money she had in the account earned interest, of course, which was added to the total savings. She calculated whatever was needed in addition to the interest income to achieve her final target, and this amount was taken out of the family wages every month and added to the account. What was taken out of wages, of course, shows up in the national accounts as the family’s savings rate. The rest is the family’s consumption rate.

When the PBoC lowered the deposit rate, this meant that if she expected to reach her target she would have to match the decrease in interest income one-for-one with an increase in the amount she saved out of monthly wages. In their case, then, a lower deposit rate was necessarily associated with a higher savings rate – and the amount this particular family consumed out of total wages declined.
As Pettis goes on to explain, part of the reason for U.S. savings rates moving along with interest rates is that a lot of wealth in the U.S. is invested in real estate and financial assets that rise in price when the interest rate falls, whereas in China, a large amount of savings is still done through bank deposits.

Read the whole thing for a discussion of how this affects the revaluation of the yuan.

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