Laura Rowley Money & Happiness

You've probably heard that the American savings rate for 2005 was negative 0.5 percent, the lowest since the Great Depression. The annual savings rate has been negative only twice -- in 1932 and 1933, during the Great Depression.

But Americans may be saving even less than the government reports. Consider the way the Commerce Department's Bureau of Economic Analysis calculates the savings rate: It takes a household's after-tax income (wages, salaries, interest income, rental income, dividends, social security, unemployment benefits, etc.) and subtracts spending on consumer goods and services (food, clothing, entertainment, etc). Whatever's left over is savings. But the government doesn't figure housing expenses into the spending-saving calculation since it views housing as an investment.

That's problematic, according to Paul Kasriel, director of economic research at Northern Trust in Chicago. "I see a lot of people buying houses that seem to have a very large consumption element to them -- like granite kitchen countertops and the huge increase in square footage per person."

Uncovering Higher Spending

So Kasriel does his own calculation of the savings rate. He subtracts not only outlays on goods and services, but also spending on a line item called "residential investment." It represents the value-added in housing -- the kitchen renovation, the family-room addition. (It also includes commissions paid to real estate brokers.)

According to Kasriel's calculation, last year Americans spent approximately $472 billion more than they earned after taxes -- a negative savings rate of 5.2 percent. That spending is double the previous year -- and a record high.

Going back to 1929, Kasriel found just a dozen years in which households spent more than they earned by his calculation. Two were during the Great Depression. Three were in the decade following World War II, when consumers unleashed pent-up savings accumulated during the war (when there was little available to consume). The other seven years of negative savings have occurred since 1999.

"What's amazing is that my generation, the rapidly aging Baby Boomers, are entering their prime saving years," Kasriel says. Most of the Boomers, representing nearly a quarter of the population, are in their peak earning years (42 to 60). Many are becoming empty nesters, so their expenses should be declining. They already own the durable goods one acquires in the early stages of adult life. "But however you slice or dice it, we aren't saving," Kasriel says.

Others economists disagree. They argue that retirees typically spend from their savings, which skews the savings rate lower. They point out that the government's calculation doesn't account for the rise in real estate values (and home equity). And while it captures things like 401(k)s and Individual Retirement Account contributions, the calculation doesn't include the capital gains on these accounts.

"If You Can't Afford It, You Can't Buy It!"

Whichever reality you believe, it's clear that Americans are highly leveraged. The ratio of debt to assets hit a near record 18.2 percent in the third quarter of 2005, the most recent data available from the Federal Reserve's Flow of Funds Database. This ratio, tracked since 1952, measures the amount of debt Americans have, relative to the market value of all their assets -- savings accounts, stocks, bonds, real estate, etc. In the early 1980s, the ratio was around 13 percent; in the early 1950s, 7 percent.

Meanwhile, the debt service ratio -- the percentage of after-tax household income that goes to cover required principal and interest payments on debt -- hit a record high of 13.75% in the third quarter of 2005, the most recent data available.

David Rosenberg, Merrill Lynch's North American chief economist, estimates that approximately $2.5 trillion dollars of adjustable-rate household debt will re-price in 2006. That works out to 23 percent of total household debt. At the same time, income growth is trending lower, Kasriel says. Put the two together, and you will end up with Americans paying an even bigger chunk of after-tax income to debt service.

By holding short-term interest rates below the inflation rate in recent years, the Fed offered juicy incentives to borrow and spend, and little to save. Low rates coincided with the advent of "creative" new mortgage instruments -- like the option ARM -- which in its simplest terms asks the borrower to send in whatever they feel like once a month, even if it barely makes a dent in the interest due (much less the principal).

The leveraged life has even become fodder for "Saturday Night Live," which recently mocked a "get out of debt" infomercial. A salesman appears in a couple's kitchen with his magical solution: "If you can't afford it, don't buy it!"

The befuddled couple responds: "I'm so confused. I don't have any money saved. Can I buy a boat?"

"No!" he booms. "If you can't afford it, you can't buy it!"

A Free-For-All That Ends Badly?

In the land of leveraged living, I'm a dinosaur. I dutifully follow the old-fashioned financial rules of the road: No revolving credit-card debt. Pay cash for your auto. Max out your annual retirement savings. Start socking money away for college when your kids are born. Put 20 percent down when you buy your home. Take out a low-interest, 30-year mortgage. Make an extra mortgage payment every year. (I know, I should probably put the extra payment in my retirement savings. It just feels good to cut years off your mortgage.)

There are a few of us savers left out there. We scratch our heads and wonder how you can buy stuff you can't pay for (or pay for twice on credit over time) and still enjoy it (see "Why It Pays to Live Within Your Means"). We're like the character in the "Princess and the Pea" fairy tale -- put the smallest credit-card bill or auto loan under a pile of mattresses, and we suffer sharp pains. We can't sleep.

Mostly, we can't help wondering if the lending and spending free-for-all of recent history will end badly -- for all of us. Imagine interest rates continuing to rise amid an employment downturn. The option ARM holders and other over-leveraged consumers put their homes on the market, or hand the keys to their lenders. The housing market experiences a sharp decline. Commercial banks, Fannie Mae, and Freddie Mac require a taxpayer bailout (a la the early 1990s) -- increasing either the current or future tax liability.

"A Marathon, Not a Sprint"

Maybe I'm paranoid. But I'm not alone. As one reader e-mailed me, "Whether we like it or not, our government has ultimate control over our financial future. In the coming years, the government will be grasping at any source of cash that they can get their hands on.... I think people sense this, consciously or subconsciously, and figure that they might as well spend now. I do worry that all my hard work and effort in being frugal will be confiscated by the government, which would make me feel foolish for not adopting a 'spend until you drop' attitude all along."

I hope the reader is wrong. Kasriel offers some consolation, suggesting savers will be the ones buying cheap foreclosures when the storm hits. "It's a marathon, not a sprint," he says, "and the people who are saving are going to be happier toward the end of the race than the ones who are spending and borrowing."