The Paradox of the Paradox of Thrift

Australian Household Savings Rate

Australian Household Savings Rate

The above graph is courtesy of Sean Carmody from A Stubborn Mule’s Perspective and http://seancarmody.posterous.com

And with Trent Hamm’s permission I’m reposting his post from The Simple Dollar on Why Saving Money is not bad for the Economy.

Two years ago (in those economic halcyon days before the so-called “Great Recession”), I wrote a short article entitled “Is Not Spending Money Bad for the Economy?” In it, I largely concluded (by my own logic) that not spending money – in other words, saving it – isn’t necessarily bad for the economy at at all.

Of course, this article was written against the backdrop of the economic conditions of the time. We were at the peak of six years of economic growth, with only the faintest hints of the economic onslaught about to occur. We, as Americans, also had a negative savings rate at the time – we were actually spending more than we earned as a whole (which meant that there were a whole lot of individuals spending far more than they earned).

Today, we live in a different world. Saving has certainly rebounded – many estimates show that the savings rate is now somewhere around 5%. The economy has certainly slowed as well, and countless trillions have been lost in a 50% dip in the stock market.

So, now’s the time to revisit that question: is saving money instead of actively spending it bad for the economy? Again, I come to the same conclusion – no – but this time, there’s a bit more food for thought on the vine.

The Paradox of Thrift
The whole idea that saving money is bad for the economy comes from the economist John Maynard Keynes, who referred to it as the “paradox of thrift.” (”Paradox of thrift” and John Maynard Keynes is one of those things you can bust out at a party to seem quite smart.) He believed that if everyone saved more money during times of recession, then demand for goods will fall. If demand for goods falls, then economic growth will stall, causing all sorts of additional economic problems (lost jobs, failed businesses, etc.).

It makes some sense on the surface. If everyone stopped spending money tomorrow, the economy would indeed fall apart. There are two big factors that keep this from happening.

First, when demand falls, prices fall, and when prices fall, people are more likely to spend money. That’s why sales always work – and thus businesses regularly have sales. If demand falls across the board, then businesses will lower their prices to get more customers.

Savings Accounts Contribute to the Economy
The second factor – and this is the big one – that makes the “paradox of thrift” fail is that putting money in savings accounts does not remove it from the economy. When you put money in a savings account, it becomes money that the bank can then lend out to businesses. Thus, when more people save, the banks have more resources to pump out to businesses, and when the businesses have more resources, they employ more people, innovate new products, and find new ways to sell.

This is a simple example of why the economy cycles back and forth between economic growth and recession. Right now, we’re in a recession and we’re putting our money away in various savings accounts and investments. That money is then being loaned out to businesses of all kinds who are taking advantage of the very low interest rates available. This means that businesses will soon begin hiring people – reducing unemployment and getting more money out there in the hands of consumers. With more people involved in steady work, more money will be spent and the economy begins to grow. Eventually, people stop saving as much – times are good. The banks then slowly close the taps since they don’t have as many resources for lending. Businesses feel the pinch and begin laying off workers – and we’re back to a recession again.

By saving, you’re actually doing your economic duty, just as you would be if you were buying things. A healthy economy needs plenty of both.

Hoarding Doesn’t Help the Economy
This, obviously, doesn’t include the guy with hundreds of dollars in his mattress or in his safe, or the guy who buys gold coins and buries them in his back yard. That type of saving (I view it as hoarding) does not help the economy at all, as it locks up money in a place where it’s not constantly being cycled back and forth between workers and employers, between businesses and customers.

If you’re concerned about whether or not saving money will help the economy, be aware that it will, but only if you actually invest it in a business (by buying stocks), in a community (by buying bonds), or in a bank where it can be distributed through business and personal loans. That way, you can not only build a safety net for yourself, but you can also do your part in making sure the economy functions like a well-oiled machine.

Trent’s argument is just as applicable to Australians.  And it seems Yasser Abdih and Evan Tanner from the IMF agree with him.  I could continue to explain how the stimulus is a good thing and how it is used to pay down debt until households are back in the black and thus investment from the stimulus will restore the economy but I think the main point has all ready been well made.

UPDATE:

As commenter Sean Carmody points out, Trent’s main argument is for those wishing to look after their own personal finance and assumes that businesses are attempting to borrow which means the savings and borrowing balances out.  Whereas the paradox of thrift is caused by both households and businesses attempting to save at the same time.  That is why the recent government stimulus is important, it will allow both households and savings pay down their debts.  Once those debts are paid, spending will commence again at a more stable level.  Some of that money will be spent anyway which in effect pays someone else their wage, then that person will spend some of their money and so on creating what is called a multiplier effect gradually restoring the economy stability.

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One response to “The Paradox of the Paradox of Thrift

  1. Senex, I’m glad you put the chart to good use!

    A couple of comments about Trent’s “second factor”.

    First, the way savings are defined in the context are simply the difference between income and expenses: if income is greater than expenses, there is saving. It does not necessarily mean that this saving goes into a “savings account” that is then lent out. For many householders, these savings may be used to repay debt. In this case, banks may simply use the receipts to pay down their own liabilities and correspondingly reduce their assets (loans) and so the money need not find it way back out to being spent.

    Second, the choice of chart and the way Trent writes, suggests that the discussion focuses only on net saving by households not businesses. In Trent’s picture, households may be saving, but businesses are borrowing (and the two net out) and so there is still spending working its way through the economy. But, what happens when households and businesses want to save? (At the moment, many businesses are also attempting to “deleverage” and pay down debt and, furthermore, many banks are not as keen to lend as they were a few years ago). Then we would seem to have problem. That’s where your reference to the stimulus comes in. If households and businesses are both, in aggregate, trying to save, then this can work if the Government spends.

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