America cannot keep to its spendthrift ways - here's a way to increase saving.

The U.S. economy is afloat today thanks only to the undaunted American consumer. Breaking the pattern seen in other downturns of the past half-century, consumption grew at a brisk pace through the three quarters of recession in 2001. Despite plunging stock prices, the spending binge continued last year, financed by record borrowing, a huge wave of mortgage refinancing and home-equity loans, a large federal tax cut, and anemic household saving. Were it not for the persistence of American shoppers, the economy would surely have headed into a tailspin.

But a credit-card recovery makes for an uncertain future. At $8 trillion, household debt in the United States exceeds Americans' annual disposable income for the first time. Debt-service burdens for both mortgages and consumer credit are at near record levels - a striking fact, considering that interest rates are close to a 40-year low. Personal bankruptcies and home foreclosures hit all-time highs last year. Despite the fact that Baby Boomers should be in their prime saving years, the household saving rate for Americans plummeted during the 1990s, dropping almost to zero in the fall of 2001 - a level not seen since the Depression. Even though the personal saving rate has risen slightly since 2001, Americans are still saving less than half the post-World War II annual average of 8.6 per cent of their after-tax income.

Our savings shortage is of particularly grave concern because to prepare for the retirement of the Boomer generation we ought to be building a more productive economy that can increase its output while relying on relatively fewer workers - and we can't do that simply by buying more cars and DVDs. Consumption may help to fuel the economy in the short term, but it is saving, not spending, that provides the capital for productive investment and long-term growth.

U.S. policy makers therefore face a dilemma. The policies they have chosen for stimulating the economy - tax cuts to encourage consumption, and low interest rates to bolster the housing market - make the long-term structural problem of under saving more severe. We have reached the point where mounting consumer debt and shrinking stock portfolios are likely to induce people to tighten their belts. But if consumer profligacy is supporting the economy, might not an abrupt spending retrenchment cause the economy to dip back into recession or worse?

Consider what would happen if the saving rate were suddenly to rise to 1990 levels: people would save more than $300 billion that they otherwise would have spent, quickly pushing GDP growth into negative territory. This is the "paradox of thrift," John Maynard Keynes's theory that increased saving can trigger lower employment, lower incomes, and ultimately slower growth.

How can we increase saving without undermining the economic recovery? During the economic boom of the mid-1990s we relied on the government to strengthen anemic national saving by running budget surpluses and paying down the national debt. More recently we have relied on consumer spending to prop up the economy during the bust. Neither practice can be sustained, however: individuals cannot keep borrowing money and liquidating home equity forever; politicians cannot be counted on to save surpluses over an extended period. What our national policy should do, then, is in fact the reverse: encourage individuals to save while the government practices deficit spending - in the short term, anyway - to keep the economy from running out of gas.

Government spending is the simple part. Congress could do many things to stimulate the economy in the short term: provide one-time tax rebates; extend unemployment benefits; accelerate public investment in infrastructure and education; spend more on defence. Any such deficit spending, however, should be temporary and targeted at stimulating the economy; as the economy recovers, the government should restrain spending, with the goal of balancing the budget over the course of the business cycle (meaning that it's okay for the government to run deficits during a recession as long as it runs surpluses during times of prosperity).

Using public policy to encourage higher levels of individual saving is harder. Fortunately, current conditions provide a golden opportunity: by reorienting President Bush's ten-year tax cut, and by changing how some of the saving incentives in the current tax code work, it would be possible both to give money back to Americans and to hold government savings constant.

We'll address the pension problem first. In many respects America's private pension system is the envy of the world. With nearly $7 trillion in assets, traditional and 401(k)-style pension plans account for the vast majority of financial assets accumulated by households in recent years. One reason the system works as well as it does is that powerful incentives, in the form of tax breaks and employer matching contributions, encourage individuals to contribute a portion of their income to an employer-sponsored saving plan. Additional reasons include the convenience and discipline provided by automatic payroll deductions, and the tax penalties that deter early withdrawals.

But our private pension system is perverse: it provides the strongest saving incentives to the affluent, who need them least, while covering fewer than half of all workers. More than 70 million Americans have no access to a tax-subsidized payroll-deduction saving plan, and therefore tend to save very little for retirement. As a result, fewer than 60 per cent of today's workers aged 47 to 64 are likely to receive benefits equal to even half their pre-retirement income when they stop working.

Even when less well-off workers are able to participate in an employer-sponsored plan, the tax incentives for saving are upside down: income-tax deductions are worth the most to high-bracket taxpayers, who need little incentive to save, whereas the lowest-paid third of workers, whose tax burden consists primarily of the Social Security payroll tax (and who have no income-tax liability), receive no subsidy at all. Federal tax subsidies for retirement saving exceed $120 billion a year but two thirds of that money benefits the most affluent 20 per cent of Americans. This is no way to structure a pension system.

The solution is to give every individual access to a tax-subsidized savings account, regardless of whether his employer sponsors a pension plan. Think of it as a government-facilitated 401(k): just as employers match contributions by eligible employees, the government would match voluntary saving by providing a refundable tax credit that would be deposited directly in workers' accounts. (Regular tax credits are simply dollar-for-dollar reductions in the total amount an individual has to pay in income taxes; a "refundable" tax credit is one that, when it is worth more than what the individual owes in income taxes, pays money directly to the individual. So even the poorest workers, who owe nothing in income tax, would automatically get direct matching contributions to their accounts from the government.) To create an even stronger incentive for saving among those who currently save least, the government should provide proportionately larger matches for saving by the bottom half of wage earners. Refundable tax credits to subsidize saving would give employers a greater incentive to contribute in behalf of low-wage and part-time workers, because even the employer's contributions would be eligible for federal matching.

Creating a universal and portable system of accounts would not be hard. Employers are already required to withhold and remit workers' income and payroll taxes. Workers could simply specify a monthly saving deduction, which employers would forward (along with other tax deductions) to an IRS clearinghouse. The Federal Thrift Savings Plan, which already manages 401(k)-style accounts for three million military and civilian federal personnel, could house small accounts. Individuals would always have the option of transferring their account balances to a private financial institution or a future employer's 401(k). The greater flexibility and portability of citizen-based savings accounts would benefit employers and employees alike.

The other part of the retirement-saving equation - Social Security - is more challenging to fix. Given the multitrillion-dollar shortfall the program is facing, the nation's retirement system is clearly in need of shoring up (it would take an immediate infusion of more than $4 trillion for the program to make good on all promised benefits over the next 75 years). Not only have the program's actual surpluses been tapped to pay for other government programs, but the mere presence of the Social Security surplus has affected budgetary decision-making by causing the federal budget to appear larger than it otherwise would. The solution is to wall off the savings that Social Security accrues by introducing a system of individually owned investment accounts that would augment - though not completely replace - the retirement benefits paid out by the current system.

There are two significant obstacles to creating individual accounts. The first is the large initial cost. Much of the money to pay benefits to future recipients will have to come from somewhere else. Simply borrowing the funds - an approach many politicians favor because it appears relatively painless - would undermine the purpose of using the accounts to build up national savings. (Personal saving would be increased but government saving would be decreased by the same amount.) It would also unfairly shift huge costs to future generations, which would be burdened with repaying the borrowed funds. The second obstacle is that personal accounts could threaten the important redistributive dimensions of the current system, whose progressive design helps those with lower incomes relatively more than those with higher incomes.

Both these obstacles can be surmounted. The start-up cost could be partially offset by setting up the private accounts with money the government now expects to lose to President Bush's ten-year tax cut. Repealing the tax cut would provide $400 billion to $1 trillion of seed funding for these accounts, enough to get them started while other necessary changes to the traditional Social Security system, such as slowing the growth of benefits and gradually increasing the retirement age, were phased in. By diverting funds into personal investment accounts for all Americans, the President could actually achieve both the effect of tax cuts (since he would still be returning money to citizens) and Social Security reform.

The redistributive aspects of the current system could be preserved by making the funding of these private accounts progressive: all American workers would get accounts but lower-income workers would get government-funded matches for their contributions. For instance, the government could contribute two dollars for every dollar saved by the lowest-income workers, one dollar for every dollar saved by workers who make slightly more, and so forth, with government subsidies phasing out at 50 cents for workers earning around the national median income. Workers would also be guaranteed a minimum benefit that would keep them out of poverty - a guarantee that Social Security does not offer at present. In short, these accounts - let's call them "progressive private accounts" - not only would help to shore up Social Security for the long term and provide workers with an additional source of retirement income, but also would maintain the program's fundamental commitment to a progressive design.

Shifting our economic priorities from consumption to saving will not be easy. But whether created separately or together, government-subsidized universal 401(k) accounts and progressive private accounts for Social Security would help individuals to prepare for retirement and would set our economy on a course for long-term prosperity. In any event, with the American consumer sinking further into debt and the retirement of the Baby Boomers fast approaching, we need to do something soon.