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Wednesday, November 12, 2008

The Paradox of Thrift

Are you feeling a bit poorer right now? Did your portfolio get a haircut lately (or a massive defoliation from head to toe)? Does the future suddenly not look as rosy to you? Are you thinking of saving more in the coming months and years (and centuries) to try and make up for recent losses?

Yeah, me too. Join the crowd.

Unfortunately, savings is inherently selfish. It's only good for the saver, not for the economy as a whole. Even worse, in a recession due to weak demand, the more we try to save in aggregate, the less we'll all end up saving. This is known as the Paradox of Thrift (or Paradox of Saving):
[It] is a paradox of economics propounded by John Maynard Keynes. The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.
The extreme case is easy to see. If we all decide to buy and consume absolutely nothing at all (i.e., save everything we make), then there would be no reason to produce anything, therefore no reason for employers to employ and pay anybody, and therefore no one would have a job or any money to save. We'd all ending up starving in the dirt.

Applying The Paradox of Thrift to the current situation, Bob McTeer, who was the President of the Federal Reserve Bank of Dallas, writes:
The problem for the economy is this: consumption makes up about 70 percent of total spending, and consumption has been supporting the economy for years even though the personal saving rate is close to zero. The reason is that individual consumers who have experienced capital gains in their homes and in their stock or mutual fund portfolios (including those in their pension funds, 401Ks, IRAs, and the like) have thought of those capital gains as saving and thus have been willing to consume virtually all of their current income. (This is legit for individuals, but not for the nation as a whole since resources aren't being made available by capital gains.)
His conclusion (which I agree with), isn't a happy one:

I've recently heard economists say that, if saving increases, it will reduce consumption; but they imply that the result will be just a reduced growth rate. Perhaps. However, if saving increases on a broad scale, as it should, based on individual circumstances, the outcome could be a severe recession. [...]

I hope I'm wrong, but this is not just a curiosity. Consumer spending is key to a recovery from the recession. A sharp decline in consumer spending would only make the recession worse even though-individually-it is the right thing to do. We are in a pickle.

Apparently, he doesn't like pickles.

So if you really want to help the country, don't save! Instead, consume till you drop!


Harry Eagar said...

Welcome to the world of Rexford Guy Tugwell, Bret. You're a little late, about 85 years, but you're gettin' there. Maybe in another 85 years you'll figure out the New Deal.

Ali said...

Domestic spending is not closely correlated with economic growth, business investment is. Pooled savings get lent out by banks to companies who need funds for expansion.

Harry Eagar said...

Not overall, maybe, but in particular sectors it is.

Housing construction, for example, is closely connected with growth, and furniture and appliance sales are closely connected with new housing.

And for sectors that are relatively large -- auto manufacturing, air travel -- consumption is growth.

But I'll agree that Tugwellism was a lot easier to spot 85 years ago when the US had a lot of small primary producers.

I expect domestic spending is closely correlated with growth in developing countries.

Harry Eagar said...

I meant to add, that's why I am so amused at the collapse of General Growth.

Even a halfwit ought to be able to at least break even renting out shopping centers (with their 8% and more rakeoff on tenant sales) in a country where 2/3 of spending is in stores.

Bret said...

harry eagar wrote: "Maybe in another 85 years you'll figure out the New Deal."

Why, so I can help ensure another deep and long depression?

I think FDR's treasury secretary Henry Moranthau's said it best to Congress in 1939: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!" [* Burton Folsom, Jr., New Deal or Raw Deal? (New York: Simon & Schuster, 2008), p. 2 -- HT: Don Boudreaux]

Unfortunately, Tugwell only understood part of the picture.

Bret said...

ali wrote: "Domestic spending is not closely correlated with economic growth..."

I'm discussing shrinkage (recession), not growth. I fully agree that once there's sufficient demand, that business investment becomes important. However, pooled savings are not required for investment when there's a fiat currency. If there's adequate business demand, the Fed simply creates more money which automatically diverts resources to business investment as the business borrow to create and buy capital goods.

Surely you'll agree that if there's no demand, no businesses are going to invest in anything?

Harry Eagar said...

'Surely you'll agree that if there's no demand, no businesses are going to invest in anything?'

Where were you in 1999?


To repeat, the New Deal did not work because it was murdered. It was working up till then. That Keynesianism did not and does not work (are you listening, Paulson?) should be obvious to all.

But tell me. How much further did equities have to fall for the market to work its magic? I mean, if 89% wassn't enough, what would have been?

Ali said...

I'm reacting more to what I'm reading and hearing on the radio here in England. The usual gang of idiots reckon government spending and domestic spending by low-income workers is going to get the country out of recession and into solid economic growth. It's like they've never heard of the failure of Keynes, the Laffer curve or why the New Deal didn't work until there was a vast monetary easing. There has been little to no discussion on easing conditions for businesses by the government. Where's the domestic demand going to come from if they're going bust and laying off workers?

Harry Eagar said...

Ah, you are sounding almost like a Tugwellian.

Cannot have a consumer society without consumers.

I like to use the example of one of America's very most popular consumer products, roller derby.

At one time, roller derby was just about the most popular sports show on TV. Until someone looked at the demographics and realized that the people who watched had essentially no disposable income.

So roller derby died.

Bret said...


Certainly one possible problem is business not being able to get credit to meet cash flow needs and going bust (I'm uncomfortably close to being able to relate to this problem). A second possibility is that businesses forecast reduced demand and stop investing and/or reduce staff.

Supply and demand have to be balanced for effective growth.