Saving for a rainy day

This week, February 20-26, 2011, is America Saves Week and I would like to write about the importance of precautionary saving.

One of the most worrisome statistics from the 2009 FINRA Financial Capability Study is that, when asked whether they had said aside sufficient funds to cover expenses for three months in case of sickness, job loss, economic downturn or other emergency, 51% of respondents (in a sample representative of America) said they do not have such precautionary funds. The crisis may have depleted some of these funds, but not having a buffer stock of savings exposes both the individual and the economy not only to a large shock but also to a small shock, such as the car breaking down, the house needing a small repair, or a sudden out of pocket health cost. And with unemployment rates as high as 10%, the lack of precautionary saving makes people not just vulnerable but also hit hard by the loss of their job.

The expansion of the opportunities to borrow may give the idea that, if an emergency arises, one can turn to credit cards or find other ways to borrow. The problem is that, in a moment of need, borrowing at high interest rates is not only problematic, but can turn quickly into higher costs and fees if one were to miss a payment, go over the limit, or use the card as a cash advance. Turning to payday lenders or similar types of loans would only further increase the cost of borrowing. The problem with these methods is that they do not provide insurance at all. One wants an instrument, like saving, that can help in time of needs, not turn to an instrument that becomes pricey when most in need.

Because it deals with emergencies that happen unexpectedly, these funds are better be liquid. One does not want to sell possessions: a car, the home, or other such items when faced with a shock. Even selling stocks may come with a stiff cost if one has to sell when the market is down. As we have experienced in the past few years, having high unemployment when the stock market plunged only accentuates the pain of job loss.

This principle is perhaps so important that even Aesop illustrates it in a fable known as The Ant and the Grasshopper. The fable concerns a grasshopper that has spent the warm months singing while the ant worked to store up food for winter. Sure enough when the winter came, the grasshopper found himself in great difficulty. I would say there are not many cases when economics crosses path with literature, but it is great when it happens. As the story says perhaps better than any equation I would write, it is a good idea to store up a little bit for those winter rainy days.

If you want to look at the statistics about who has saving for a rainy day, here is the link to the state-by-state Financial Capability Study data: