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Chance Can Be a Better Way To Save

Author: Peter R. Orszag, Adjunct Senior Fellow
February 16, 2011
Financial Times

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In all the recent debate over budget deficits, few people have noticed that America has started saving again. Personal saving in the US has risen from 1.4 per cent of income in 2005 to 5.8 per cent in 2010, and new data this week from the Federal Reserve confirm the higher savings rates are continuing. A dramatic, sudden further increase in saving would harm the recovery. But as the world gradually emerges from the economic downturn, global rebalancing means the US and Europe must save more over time. Savings lotteries, like Britain's popular Premium Bonds, can provide an intriguing way forward.

No one can deny that people love lotteries. In 2008 Americans spent more on lottery tickets than on beer, or milk. Low-income families, in particular, spend a higher share of their income on tickets. Critics are quick to pounce, though, on the costs: spending $1 on a state lottery ticket produces an expected loss of roughly 50 cents, on average. These losses, often borne by poorer families, mirror the revenue gained by the state governments who run the games. Lotteries are thus a regressive form of financing, and attacked by advocates for the poor.

One reason for their enduring popularity may be that lotteries offer a (highly improbable) chance for a massive increase in wealth otherwise unavailable to poorer families. Research suggests that winning the lottery produces only an ephemeral increase in happiness, but that's not how it seems before winning.

In the quest to raise saving rates, this allure of lotteries may be quite helpful. To be sure, most of any increase in national savings will come from a reduction in budget deficits. But a secondary priority is higher household savings, especially among lower- and middle-income groups. In addition to the macroeconomic need, asset building for moderate and even middle-income households provides a much-needed cushion against the vagaries of life. As too many families have discovered over the past few years, building up a nest egg can be the crucial difference between weathering an economic storm or and being battered by it.

This is where prizes can help. A recent paper for the National Bureau of Economic Research laid out the case for a savings vehicle coupled to the opportunity of winning a large prize. One way to think of these “prize-linked” accounts is that they can offer an expected market return, but in an innovative way. They pay a guaranteed return below market interest rates, but also provide a lottery ticket whose value makes up the difference.

To be specific, a lottery-lined savings account could offer a lower rate of interest, but also say a one-in-a-million chance of winning $1m for each $100 deposited. Mathematically, the expected return is the same, but the chance to win $1m makes the account much more attractive.

Britain has historically led the way with these sorts of savings opportunities, starting with the “million adventure” lottery in 1694. Households were offered 100,000 tickets at £10 each, with poorer groups able to club together to buy fractions of tickets. Holders received a 6 per cent annual return for 15 years, plus the opportunity to win a prize of between £10 and £1,000. Historians suggest the programme was popular and successful. More recently, much the same theory was seen in the UK's Premium Savings Bonds, which offer the opportunity to win a prize but no base interest rate. From Brazil to Germany, Mexico to New Zealand, a variety of other prize-linked savings opportunities already exists.

The problem is these schemes tend to be small and limited. In the US, modest pilots have been tried, for instance in Indiana, by the Doorways to Dreams non-profit. Yet the basic concept is tested, and it seems time to try it more aggressively to see if it can grow and also if this form of saving merely displaces other forms, rather than actually raising the total too. In short, in the coming decade we need a comprehensive effort to raise household savings. As part of that push, let's give savings accounts linked to lotteries a chance. It is a gamble, but it could well pay off handsomely.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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