Savers under siege

The attack on savers has not been so intense since the 1940s when there was a tax surcharge on 'unearned income' and compulsory wartime savings – dubbed post-war credits – were not fully repaid by niggardly chancellors of the exchequer for 30 years, and then only after inflation had taken huge bites.

That said, in the new campaign against savers launched over the past two years interest rates on short-term deposits have been cut to just about zero, longer-term bond yields (and thus annuity rates) have been artificially suppressed through quantitative easing, the capital gains tax rate has been increased and tax relief on pension contributions has been slashed, at least for higher earners.

Search through policy documents, however, and you will find no direct mention of any official plan to curb savings, whether by the Labour government or the present Tory-LibDem coalition.

True, perhaps we should be grateful that we did not suffer big 'haircuts' on deposits with failing banks, not even at Northern Rock or Icesave. We may have to accept that we should pay a price, but we have not been formally invoiced.

Feeling the financial burden

In August, however, the Bank of England gave a dark warning in its quarterly Inflation Report.

If the government is really to succeed in cutting its financial deficit sharply, from £155 billion to £85 billion within three years, then the other economic sectors – companies, individuals and foreigners – which have recently been in positive financial balance, will have to accept reduced surpluses or even deficits.

For the private sector, that implies lower savings. In fact, the government has implied an official excuse for hammering savers: incentives to save must be reduced so that people spend more.

There was a clear hint about this last year when the net financing target of National Savings & Investments was cut to zero – no net new savings, please.

Meanwhile, borrowers have been handed a huge windfall. Over the past two years, the average rate on variable mortgages has halved from six to 3%.

This is all reminiscent of the 'paradox of thrift', discussed by John Maynard Keynes in his General Theory, published in 1936.

In a depressed world, saving reduces spending and puts people out of work. When, so the paradox goes, individuals save for their future security they undermine the broad economy.

In economics, however, there are always other views. After all, savings provide finance for capital investment and such investment generates economic growth. Destroy savings and the economy will seize up and crumble.

The trouble is, whereas savers are usually planning for the long term – for security in old age, even for the prosperity of the family's next generation – politicians think no further ahead than the next election.

David Cameron may hope to have four-and-a-half years to go but Barack Obama faces mid-term elections in November and his own re-election campaign in just two years' time.

The economic recovery on both sides of the Atlantic has been feeble and the dreaded double-dip looms. Desperate measures may well be taken to halt the rise of unemployment.

On this side of the Pond, the Bank of England's monetary policy committee has clearly given up the battle against inflation.

It has missed its 2% CPI target for many months and yet refuses to raise interest rates. Instead it relies on increasingly unbelievable forecasts of lower inflation in future.

But is the new chancellor, George Osborne, unhappy about this? No, certainly not: "I welcome the committee's flexibility,' he wrote to Bank governor Mervyn King in August.

A turning point may well come soon with a decision to launch another round of quantitative easing. This could provide a clear sign that the British government will opt for high inflation to reduce the burden of its mountainous debt.

Buyers of British government bonds are certainly vulnerable because yields on 10-year gilt-edged bonds have sunk to less than 3%.

Do investors in gilts know what they are doing? I am reminded of what happened back in the early 1960s when RPI inflation was roughly what it is now (around 4%) and long-dated gilt yields were 5 to 6%.

Inflation over the following 20 years wiped out more than 80% of the real value of those gilts. The market can get things horribly wrong.

Last time, double-digit inflation was blamed on trade unions and oil sheikhs. This time, if it happens again, the Treasury will blame it on Gordon Brown, the Chinese and hedge funds speculating against sterling.

But the direct cause of inflation is always the same: governments taking the easy way out.

Nowhere to hide

Unfortunately, there are no safe havens for investors. Already they have had to retreat from 'safe' deposits where they now, in effect, have to pay a 5% annual liquidity fee simply to park their funds (RPI inflation plus tax).

It is also almost time to exit from fixed-income gilts and bonds, which have held up surprisingly well so far but are no longer offering yields that compensate for the risks.

This leaves investors with various, less-liquid alternatives. Diversified equities will pay off in the long run but will continue to be very volatile in price (as they have been so far this year).

Residential property will remain a store of value but it is rather expensive at present, and is exposed to the effects of the current pressure on real incomes; first-time buyers are increasingly squeezed out of the housing market.

The last resorts are inflation-protected government bonds and gold bullion. They are proof against inflation but not against political risk.

Already, National Savings & Investments has withdrawn its index-linked certificates from sale because they provided a too-popular oasis of value in a savings desert.

Gold is a reality check. It has been hitting all-time highs this year, even though US and German government bond yields have been at low levels not seen for 50 years, if ever.

It almost seems that investors are ready to hedge against hyperinflation and deflation at the same time.

The really rich may also consider alternative asset classes, such as Old Masters, farmland in East Anglia or classic cars. These will not reliably pay the care home bills in old age but such assets may, at least, preserve some wealth for the next generation.

Overseas assets provide another essential ingredient of a diversification strategy. But where is financially safer than the UK? Not the US, anyway, and the eurozone is under a cloud.

Traditional boltholes, such as Switzerland, are fighting to stop their currencies appreciating as nervous capital sloshes around the globe.

Financial advisers suggest moving portfolios to countries where there is still some growth, such as China, India or Brazil. But the risks are high.

Still, it is not yet time to panic. The coalition government has at least declared its intention to regain control over the public finances.

Some good news on economic growth and government revenues could allow us to look beyond the crisis and see stability.

Investors, however, must be prepared to dig in and doggedly preserve what they have saved.

This article was originally published in Money Observer - Moneywise's sister publication - in October 2010

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