"The Paradox of Thrift"

Yet another product from the fertile mind of John Maynard Keynes is the "Paradox of Thrift". In its most simple form, it says that if people save more and spend less, then the people who make and sell goods will receive less income, and having less, will be able to save less, while simultaneously beggaring the economy. This idea is readily embraced by liberals (Matthew Yglesias, Paul Krugman), because as the flip side of Keynesian stimulus (the idea that if people spend more then there will be more money to spend and the economy will improve), it justifies two concepts dear to the liberal mind: deficit spending (spending money one doesn't have), and forced spending (taking money from people who have it to spend it on other things, more commonly known as "theft").

Paul Krugman, the Nobel prize winning Democrat economist who is so factually challenged as to have his own watch site (www.krugmanwatch.com) and his own paper's public editor chastise him, takes the "paradox of thrift" so far as to attribute the recession to decreased consumerism:

Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.

In point of fact, the "paradox of thrift" had fallen out of fashion well before today's resurrection (The Paradox of Thrift:RIP - Cato Journal), because it was recognized as false. Keynes' "paradox" ignored two important forces: that saved money is not "idle" money, and that investment, not consumption, is the engine of growth.

[When Keynes] wrote in 1936 that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” [he] surely did not have himself in mind. But, in times of trouble, Americans still cling to Keynes, or at least to the caricature of him as the economist who said you could spend your way out of a recession. His big idea was that, left to its own devices, an economy can fall into a slump and just stay there. Self-corrective mechanisms will not necessarily work on their own; they will need help.

Prosperity depends on investment, on businesses building new plants, buying new machines, and employing more workers. In a typical case, when an economy slows, businesses reduce their demand for credit. At the same time, worried consumers save their earnings in banks, and by doing so, add to the store of money available for lending. These two forces—as well as actions taken by the Federal Reserve Board—combine to push interest rates to levels so attractive that businesses start borrowing again, and the economy picks up. The Great Depression, however, was atypical. The economy slowed and interest rates fell, but businesses were so frightened about the future that they refused to invest; instead, they did the opposite, shutting plants and firing workers. As for consumers, while they may have wanted to save, they lacked the cash to put away. Because they were out of work, they depleted what savings they had.

Stimulus: A History of Folly - James K. Glassman, Commentary

I can best illustrate the theory, and the reality with a little parable. First, Keynesian "paradox":

Imagine 100 workers in a town, each earning $100 a week. Their weekly expenses are $90, leaving $10 each to spend as they wish. Under the "paradox of thrift", if they each save $1, then the reduced consumption will lead to less demand, and one of the workers will have to be laid off, or their wages will have to be reduced. If they spend that extra $1, all is well, and if they each borrow some money, and spend that too, then because of increased demand another worker will be hired, or their wages will raised.

Now, for the supply side example:

Imagine the same workers in the same town, with the same wages and same expenses, but now, when they each save $1, an entrepreneur has come to town to borrow the $100 they have all saved in aggregate, and to begin a business. The entrepreneur will also spend $99, and save only $1, so there will be a slight reduction in aggregate demand of 1/100th of 1%, but in return there is an increase in productivity of 1%. The overall economy has improved far in excess of what was possible solely through consumption.

Note that it is not strictly necessary that the new production be a consumable commodity. It is an accepted truism for business that downturns are when you position your company for the resurgence. Companies may invest in knowledge or expertise. During their start-up phases, venture financed companies sell nothing, and supply no consumption, yet they consume savings and employ workers while building intellectual capital. Keynes' "paradox" allows no room for these activities.

I saw a bumper sticker a while back that read, Consume Less, Share More. In a way, that is what supply side economics advises. By consuming less, and saving some of our income, we make that income available to others who would put it to work in new ways, hiring people, buying equipment, and generally enriching society. By saving, we are also sharing, through the intermediaries of our banking and investment system.

Saving is a method for delayed gratification. One reason may be that we are saving for a large purchase - a car or a home. Another may be that we are saving for retirement. Investing in new enterprises that produce some future good is yet another example of delayed gratification. In all these cases we defer instant gratification for a future good - a car, a secure retirement, a new technology that makes our life longer, or better.

Yet another benefit of using the banking and investment system is that professionals are supposed to be better at determining risk and deciding who should receive the use of our savings. Lending to your friends or relatives can be an easy way to ruin a relationship. Unfortunately, in the lead up to this current recession savers were let down by the professionals, who had lent money to some questionable ventures. In consequence, savers are reluctant to trust their money to any but the most guaranteed investments. Money is not being made available to the entrepreneurs who create businesses and opportunities. Is it not far more likely that rather than being caused by a lack of consumption, our economic downturn has been caused by a lack of confidence in investment? Rather than chastising savings, would not our economic future be better served by encouraging renewed savings, and taking steps to increase investor confidence? But that is a topic for another post.