Economic theories, like the paradox of thrift, help explain common, observable behaviors and outcomes in financial markets. They also are the basis for strategies to deal with economic problems. We are familiar with concepts such as supply and demand, but there are more than fifty economic theories, many of which were interpreted by renowned economist John Maynard Keynes. His ideas profoundly impacted the way the United States government approached monetary policy in the 20th century.
What is the paradox of thrift?
The paradox of thrift states that personal savings can be detrimental to economic growth, especially during a recession. If people prioritize personal savings in place of spending, they withhold money from the economy, which can lag as a result. Economies without a sufficient cash flow cannot grow or create jobs which can prolong a recession.
The theory argues that if individuals cut spending to increase saving, the aggregate savings will eventually fall because “one person’s spending is someone else’s income.” Thus, increased saving decreases consumption and stifles demand.
Origin of the Paradox of Thrift
The paradox of thrift, also known as the paradox of income, was popularized by John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936). Keynes asserts that the proper response to a recession is to encourage consumer spending.
“…incomes, in general, are not independent, quite the contrary, of the disposition of individuals to spend and invest; and since in turn, the readiness of individuals to spend and invest depends on their incomes, a relationship is set up between aggregate savings and aggregate investment which can be very easily shown, beyond any possibility of reasonable dispute, to be one of exact and necessary equality.”The General Theory of Employment, Interest, and Money (1936)
The notion that extreme saving can hurt an economy has roots that predate Keynes. In his book Keynes credits Bernard Mandeville’s fable of the bees “The Grumbling Hive, or Knaves turn’d honest” (1714) as the first conceptual example of the paradox.
The Fable is an allegorical poem about the plight of a prosperous town where all the citizens suddenly decide to turn their backs on luxury in the interest of saving money. The poem concludes with the following commentary from Mandeville:
“As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.”The Grumbling Hive, or Knaves turn’d honest (1714)
Economists of the 19th century frequently wrote about underconsumption. Ideas akin to what became the paradox of thrift were suggested by author John M. Robertson (The Fallacy of Savings 1892) and economists William Trufant and Waddill Catchings (Money 1928), all of whom Keynes would no doubt have known and read.
Wait? Does That Mean Saving is Bad?
No, saving is still a great idea at the individual level. However, the paradox of thrift teaches us the extent to which consumer spending stimulates the economy and is often the way through a recession.
Consumers often behave predictably, and rarely do they have to be told to spend more instead of saving. We do that instinctively. In fact, during hard times, we tend to sacrifice savings first to maintain our standard of living. Still, if a recession is bad enough, the balance between saving and spending can be unseated.
For example, unemployment and COVID-19 lockdown restrictions both had a significant impact on spending in 2020. While Americans continued to spend on necessities and consumer goods they could no longer spend money in places closed by the pandemic, which impacted overall spending considerably.
Consumer Spending During The Great Recession
Data shows that consumer spending consistently makes up around two-thirds of the economy and is an important indicator of economic health.
During the Great Recession of 2007 to 2009, saving increased in an unprecedented way. Before the recession, the average savings rate for a typical household was around 2.9 percent. After the recession began, that rate rose to 5 percent. Employment uncertainty and wide fluctuations in stock and housing prices are considered the catalyst for this fear-based savings trend.
At the time, and in retrospect, economists argue that the saving trend prolonged the recession and was detrimental to the economy.
The Importance of Economic Theories on Government Policy
Theories are ideas that explain actions or outcomes by making connections between cause and effect. However, theories are not necessarily statements of fact. They can be proven or disproven over time as evidence is collected. Theories can be flawed and contain ideas that are partially true or false. They can also be disputed or political.
For example, trickle-down economics was a popular theory that took center stage in the 1980 presidential primary between Ronald Regan and George H. W. Bush. When the former won the primary and Presidential election, trickle-down policies, or Reaganomics, as they were often called, were put in place. The theory became the basis for tax cuts and reforms that would go on to define an entire generation.
The principles of the paradox of thrift influence policymakers to stimulate consumer spending during a recession. This can be achieved in various ways, many of which have been implemented during the coronavirus pandemic.
To stimulate consumer spending, the government:
- Instated an eviction moratorium
- Issued stimulus checks
- Lowered federal reserve interest rates
- Increased unemployment benefits
Criticism of the Paradox of Thrift
Although sound in its reasoning, the paradox of thrift has invited criticisms from economists who often focus on three significant flaws in the theory.
- The Paradox of thrift ignores Say’s law and capital goods spending.
- The paradox of thrift ignores the impact of inflation and deflation.
- The paradox of thrift ignores saved income that is invested or lent out by banks.
Criticism #1: The Paradox of thrift ignores Say’s law and capital goods spending.
For the paradox of thrift theory to work, it relies on another theory called the circular flow model. The model demonstrates how money moves through an economy in a simplified loop from consumers to producers and back to consumers. Economies are rarely this simple, so the model is not exhaustive, but it does create a visual representation of the system upon which the paradox of thrift is applied.
Critics point to how the circular flow model conflicts with Say’s law, a theory that points to production as the catalyst for spending, rather than the other way around. To those of us who are not professional economists, this may seem like a chicken or the egg scenario. Which came first, production or spending? Do we spend because we produce, or do we produce because people spend?
That’s a tricky question to answer, but we know that the circular flow model overlooks capital goods (goods created so that other goods can be produced) or B2B (business to business) transactions.
Similarly, if consumer spending decreases, producers will lower the cost of goods to move those goods. Lower prices reinvigorate demand allowing the market to recover. Affirming Say’s law which says that supply creates its own demand.
Criticism #2: The paradox of thrift ignores the impact of inflation and deflation.
The paradox of thrift also does not speak to the impact of inflation or deflation: Notably, it is suggested that if increased savings during a recession forces future prices to fall, future production and employment need not decline as Keynes predicted. Increased domestic savings can lead to lower domestic inflation and therefore increase exports. An increase in exports will lead to an increase in overall demand that offsets the impact of domestic savings.
Criticism #3: The paradox of thrift ignores saved income that is invested or lent by banks
Finally, the paradox of thrift doesn’t address the possibility that saved income can be lent out by banks. When enough individuals increase their savings, interest rates tend to fall, and in turn, banks make additional loans.
Keynes responded to these objections by arguing Say’s law was wrong because prices are not that flexible. It seems economists are divided in their views. Nevertheless, an uptick in consumer saving can be viewed by the market as a signal of supply-side inefficiency.
Lessons from The Paradox of Thrift
Valid criticisms aside, the paradox of thrift, like all economic theories, invites us to examine individual and group behaviors and ask important questions about their impact. The paradox teaches us that when consumer savings outpace consumer spending the system is out of balance. The reasons why it is out of balance, or the subsequent solutions remain up for debate.
When consumers spend less, producers will instinctively be drawn to optimize future output to attract consumers. When the economy stalls, governments may try to stimulate changes in consumer spending and saving.
Prioritize Balance in Your Spending and Savings Habits
When you make personal decisions about what to spend and save, you are not likely to be thinking about macroeconomic theories from the 19th and 20th centuries. Nevertheless, these theories do have an indirect impact on your life, especially during economic recessions.
When deciding what to do with your money, a balanced approach seems best. When regular saving is a part of your everyday budget, your normal spending is less likely to be disrupted by financial emergencies or economic recessions.